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SECURITY ANALYSIS

“Many shall be restored that now are fallen and many
Shall fall that now are in honor”

Horace —Ars Poetica.

SECURITY ANALYSIS

Principles and Technique

BENJAMIN GRAHAM

Investment Fund Manager; Lecturer in
Finance , Columbia University

AND

DAVID L. DODD

Associate Professor of Finance
Columbia University

Second Edition
Tenth Impression

McGRAW-HILL BOOK COMPANY, Inc.

NEW YORK AND LONDON

1040

PRINTED IN THE UNITED ^TAT^&^Mt AMEMcA

All rights reserved . This hook, or
parts thereof, may not he reproduced
in any form without permission of
the publishers .

THE MAPLE PRESS COMPANY, PORK, PA.

ROSWELL C. McCREA

PREFACE TO THE SECOND EDITION

The lapse of six years since first publication of this work sup¬
plies the excuse, if not the necessity, for the present comprehensive
revision. Things happen too fast in the economic world to
permit authors to rest comfortably for long. The impact of a
major war adds special point to our problem. To the extent
that we deal with investment policy we can at best merely hint
at the war's significance for the future. As for security analysis
proper, the new uncertainties may complicate its subject matter,
but they should not alter its foundations or its methods.

We have revised our text with a number of objectives in view.
There are weaknesses to be corrected and some new judgments
to be substituted. Recent developments in the financial sphere
are to be taken into account, particularly the effects of regulation
by the Securities and Exchange Commission. The persistence
of low interest rates justifies a fresh approach to that subject;
on the other hand the reaffirmance of Wall Street's primary
reliance on trend impels us to a wider, though not essentially
different, critique of this modern philosophy of investment.

Although too great insistence on up-to-date examples may
prove something of a boomerang, as the years pass swiftly, we
have used such new illustrations as would occur to authors
writing in 1939-1940. But we have felt also that many of the
old examples, which challenged the future when first suggested,
may now possess some utility as verifiers of the proposed tech¬
niques. Thus we have borrowed one of our own ideas and have
ventured to view the sequel to all our germane 1934 examples
as a “laboratory test" of practical security analysis. Reference
to each such case, in the text or in notes, may enable the reader
to apply certain tests of his own to the pretensions of the securi¬
ties analyst.

The increased size of the book results partly from a larger
number of examples, partly from the addition of clarifying mate¬
rial at many points and perhaps mainly from an expanded treat¬
ment of railroad analysis and the addition of much new statistical

vii

viii PREFACE TO THE SECOND EDITION

material bearing on the exhibits of all the industrial companies
listed on the New York Stock Exchange. The general arrange¬
ment of the work has been retained, although a few who use it
as a text have suggested otherwise. We trust, however, that
the order of the chapters can be revised in the reading, without
too much difficulty, to convenience those who prefer to start,
say, with the theory and practice of common-stock analysis.

Benjamin Graham.

David L. Dodd.

New York, New York,

May, 1940.

PREFACE TO THE FIRST EDITION

This book is intended for all those who have a serious interest
in security values. It is not addressed to the complete novice,
however, for it presupposes some acquaintance with the terminol¬
ogy and the simpler concepts of finance. The scope of the work
is wider than its title may suggest. It deals not only with meth¬
ods of analyzing individual issues, but also with the establishment
of general principles of selection and protection of security hold¬
ings. Hence much emphasis has been laid upon distinguishing
the investment from the speculative approach, upon setting up
sound and workable tests of safety, and upon an understanding
of the rights and true interests of investors in senior securities
and owners of common stocks.

In dividing our space between various topics the primary but
not the exclusive criterion has been that of relative importance.
Some matters of vital significance, e.g., the determination of the
future prospects of an enterprise, have received little space,
because little of definite value can be said on the subject. Others
are glossed over because they are so well understood. Conversely
we have stressed the technique of discovering bargain issues
beyond its relative importance in the entire field of investment,
because in this activity the talents peculiar to the securities
analyst find perhaps their most fruitful expression. In similar
fashion we have accorded quite detailed treatment to the char¬
acteristics of privileged senior issues (convertibles, etc.), because
the attention given to these instruments in standard textbooks
is now quite inadequate in view of their extensive development
in recent years.

Our governing aim, however, has been to make this a critical
rather than a descriptive work. We are concerned chiefly with
concepts, methods, standards, principles, and, above all, with
logical reasoning. We have stressed theory not for itself alone
but for its value in practice. We have tried to avoid prescribing
standards which are too stringent to follow, or technical methods
which are more trouble than they are worth.

PREFACE TO THE FIRST EDITION

The chief problem of this work has been one of perspective—
to blend the divergent experiences of the recent and the remoter
past into a synthesis which will stand the test of the ever enig¬
matic future. While we were writing, we had to combat a wide¬
spread conviction that financial debacle was to be the permanent
order; as we publish, we already see resurgent the age-old frailty
of the investor—that his money burns a hole in his pocket. But
it is the conservative investor who will need most of all to be
reminded constantly of the lessons of 1931-1933 and of previous
collapses. For what we shall call fixed-value investments can be
soundly chosen only if they are approached—in the Spinozan
phrase—“from the viewpoint of calamity.” In dealing with
other types of security commitments, we have striven throughout
to guard the student against overemphasis upon the superficial
and the temporary. Twenty years of varied experience in Wall
Street have taught the senior author that this overemphasis is at
once the delusion and the nemesis of the world of finance.

Our sincere thanks are due to the many friends who have
encouraged and aided us in the preparation of this work.

Benjamin Graham.
David L. Dodd.

New Yoke, New York,

May, 1934.

CONTENTS

Paqb

Preface to the Second Edition .vii

Preface to the First Edition .... .ix

v Introduction. 1

PART I

SURVEY AND APPROACH

Chapteb

I. The Scope and Limits of Security Analysis. The
Concept of Intrinsic Value. 17

> „It. Fundamental Elements in the Problem of Analysis.

Quantitative and Qualitative Factors. . 31

III. Sources of Information. . . 46

IV. Distinctions between Investment and Speculation. . 67

V. Classification of Securities. 69

PART II

FIXED-VALUE INVESTMENTS

VI. The Selection of Fixed-value Investments. 77

VII. The Selection of Fixed-value Investments: Second

and Third Principles ... 91

VIII. Specific Standards for Bond Investment. 106

IX. Specific Standards for Bond Investment ( Continued ) 117

X. Specific Standards for Bond Investment ( Continued ). 134

XI. Specific Standards for Bond Investment ( Concluded ). 145

XII. Special Factors in the Analysis of Railroad and

Public-utility Bonds. 167

XIII. Other Special Factors in Bond Analysis. 177

XIV. The Theory of Preferred Stocks. 184

CONTENTS

xii

Chaptbb

XV. Technique of Selection of Preferred Stocks for

Investment .196

XVI. Income Bonds and Guaranteed Securities .208

XVII. Guaranteed Securities ( Continued) .220

XVIII. Protective Covenants and Remedies of Senior Secu¬
rity Holders.236

XIX. Protective Covenants ( Continued) . 249

XX. Preferred-stock Protective Provisions. Mainte-

ance of Junior Capital. . . 261

XXI. Supervision of Investment Holdings 274

PART III

SENIOR SECURITIES WITH SPECULATIVE FEATURES

XXII. Privileged Issues. .... 284

XXIII. Technical Characteristics of Privileged Senior

Securities. 296

XXIV. Technical Aspects of Convertible Issues 308

XXV. Senior Securities with Warrants. Participating

Issues. Switching and Hedging. 318

XXVI. Senior Securities of Questionable Safety . 330

PART IV

THEORY OF COMMON-STOCK INVESTMENT.

THE DIVIDEND FACTOR

XXVII. The Theory of Common-stock Investment . . . 343

XXVIII. Newer Canons of Common-stock Investment 362

XXIX. The Dividend Factor in Common-stock Analysis. . . . 372

XXX. Stock Dividends. 389

PART V V

ANALYSIS OF THE INCOME ACCOUNT.

THE EARNINGS FACTOR IN COMMON-STOCK VALUATION

XXXI. Analysis of the Income Account .401

XXXII. Extraordinary Losses and Other Special Items in the

Income Account. 416

CONTENTS

x iii

Cbaptsb Fags

XXXIII. Misleading Artifices in the Income Account. Earn¬
ings of Subsidiaries. . . 427

XXXIV. The Relation of Depreciation and Similar Charges

to Earning Power.445

XXXV. Public-utility Depreciation Policies.465

XXXVI. Amortization Charges from the Investor’s Standpoint 472

XXXVII. Significance of the Earnings Record. . 506

XXXVIII. Specific Reasons for Questioning or Rejecting the

Past Record. 521

XXXIX. Price-earnings Ratios for Common Stocks. Adjust¬
ments for Changes in Capitalization . . 530

XL. Capitalization Structure.541

XLI. Low-priced Common Stocks. Analysis of the Source

of Income. ... . 554

PART VI

BALANCE-SHEET ANALYSIS. IMPLICATIONS OF ASSET VALUES

XLII. Balance-sheet Analysis. Significance of Book Value 567

XLIII. Significance of the Current-asset Value . 578

XLIV. Implications of Liquidating Value. Stockholder-

management Relationships ... .... 594

XLV. Balance-sheet Analysis ( Concluded ) . 611

PART VII

ADDITIONAL ASPECTS OF SECURITY ANALYSIS.
DISCREPANCIES BETWEEN PRICE AND VALUE

XLVI. Stock-option Warrants.635

XLVII. Cost of Financing and Management. . . 648

XLVIII. Some Aspects of Corporate Pyramiding . . 659

XLIX. Comparative Analysis of Companies in the Same Field 669

L. Discrepancies between Price and Value.684

LI. Discrepancies between Price and Value ( Continued ) . 704

Appendix. • 729

Index. 831

SECURITY ANALYSIS

INTRODUCTION

PROBLEMS OF INVESTMENT POLICY

Although, strictly speaking, security analysis may be carried
on without reference to any definite program or standards of
investment, such a specialization of functions would be quite
unrealistic. Critical examination of balance sheets and income
accounts, comparisons of related or similar issues, studies of
the terms and protective covenants behind bonds and preferred
stocks—these typical activities of the securities analyst are
invariably carried on with some practical idea of purchase or
sale in mind, and they must be viewed against a broader back¬
ground of investment principles, or perhaps of speculative pre¬
cepts. In this work we shall not strive for a precise demarcation
between investment theory and analytical technique but at
times shall combine the two elements in the close relationship
that they possess in the world of finance.

It seems best, therefore, to preface our exposition with a
concise review of the problems of policy that confront the
security buyer. Such a discussion must be colored, in part at
least, by the conditions prevailing when this chapter was written.
But it is hoped that enough allowance will be made for the
possibility of change to give our conclusions more than passing
interest and value. Indeed, we consider this element of change
as a central fact in the financial universe. For a better under¬
standing of this point we are presenting some data, in conspectus
form, designed to illustrate the reversals and upheavals in values
and standards that have developed in the past quarter century.

The three reference periods 1911-1913, 1923-1925 and 1936-
1938 were selected to represent the nearest approximations to
“normal,” or relative stability, that could be found at intervals
during the past quarter century. Between the first and second

Financial and Economic Data fob Thbeb Reference Periods

SECURITY ANALYSIS

INTRODUCTION

SECURITY ANALYSIS

triennium we had the war collapse and hectic prosperity, followed
by the postwar hesitation, inflation, and deep depression.
Between 1925 and 1936 we had the “new-era boom,” the great
collapse and depression, and a somewhat irregular recovery
towards normal. But if we examine the three-year periods
themselves, we cannot fail to be struck by the increasing tendency
toward instability even in relatively normal times. This is
shown vividly in the progressive widening of the graphs in
Chart A, which trace the fluctuations in general business and
industrial stock prices during the years in question.

It would be foolhardy to deduce from these developments that
we must expect still greater instability in the future. But it
would be equally imprudent to minimize the significance of
what has happened and to return overreadily to the comfortable
conviction of 1925 that we were moving steadily towards both
greater stability and greater prosperity. The times would
seem to call for caution in embracing any theory as to the future
and for flexible and open-minded investment policies. With
these caveats to guide us, let us proceed to consider briefly
certain types of investment problems.

A. INVESTMENT IN HIGH-GRADE BONDS AND PREFERRED

STOCKS

Bond investment presents many more perplexing problems
today than seemed to be true in 1913. The chief question then
was how to get the highest yield commensurate with safety; and
if the investor was satisfied with the lower yielding standard
issues (nearly all consisting of railroad mortgage bonds), he
could supposedly “buy them with his eyes shut and put them
away and forget them.” Now the investor must wrestle with a
threefold problem: safety of interest and principal, the future of
bond yields and prices, and the future value of the dollar. To
describe the dilemma is easy; to resolve it satisfactorily seems
next to impossible.

1. Safety of Interest and Principal.—Two serious depressions
in the past twenty years, and the collapse of an enormous volume
of railroad issues once thought safe beyond question, suggest
that the future may have further rude shocks for the complacent
bond investor. The old idea of “permanent investments,”
exempt from change and free from care, is no doubt permanently

INTRODUCTION

gone. Our studies lead us to conclude, however, that by suffi¬
ciently stringent standards of election and reasonably frequent
scrutiny thereafter the investor should be able to escape most
of the serious losses that have distracted him in the past, so that
his collection of interest and principal should work out at a
satisfactory percentage even in times of depression. Careful
selection must include a due regard to future prospects, but
we do not consider that the investor need be clairvoyant or that
he must confine himself to companies that hold forth exceptional
promise of expanding profits. These remarks relate to (really)
high-grade preferred stocks as well as to bonds.

2. Future of Interest Rates and Bond Prices.—The unprece¬
dentedly low yields offered by both short- and long-term bond
issues may well cause concern to the investor for other reasons
than a natural dissatisfaction with the small return that his
money brings him. If these low rates should prove temporary
and are followed by a rise to previous levels, long-term bond
prices could lose some 25%, or more, of their market value.
Such a price decline would be equivalent to the loss of perhaps
ten years’ interest. In 1934 we felt that this possibility must be
taken seriously into account, because the low interest rates then
current might well have been a phenomenon of subnormal
business, subject to a radical advance with returning trade
activity. But the persistence of these low rates for many years,
and in the face of the considerable business expansion of 1936-
1937, would argue strongly for the acceptance of this condition
as a well-established result of a plethora of capital or of govern¬
mental fiscal policy or of both.

A new uncertainty has been injected into this question by the
outbreak of a European war in 1939. The first World War
brought about a sharp increase in interest rates and a correspond¬
ing severe fall in high-grade bond prices. There are sufficient
similarities and differences, both, between the 1914 and the 1939
situations to make prediction too risky for comfort. Obviously
the danger of a substantial fall in bond prices (from the level of
early 1940) is still a real one; yet a policy of noninvestment
awaiting such a contingency is open to many practical objections.
Perhaps a partiality to maturities no longer than, say, fifteen
years from purchase date may be the most logical reaction to
this uncertain situation.

COURSE OF AMERICAN BUSINESS
AND INDUSTRIAL STOCK PRICES

SECURITY ANALYSIS

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INTRODUCTION

J.N30 U3d

SECURITY ANALYSIS

For the small investor, United States Savings Bonds present
a perfect solution of this problem (as well as the one preceding),
since the right of redemption at the option of the holder guarantees
them against a lower price. As we shall point out in a more
detailed discussion, the advent of these baby bonds has truly
revolutionized the position of most security buyers.

3. The Value of the Dollar.—If the investor were certain
that the purchasing power of the dollar is going to decline sub¬
stantially, he undoubtedly should prefer common stocks or
commodities to bonds. To the extent that inflation, in the
sense commonly employed, remains a possibility, the investment
policy of the typical bond buyer is made more perplexing. The
arguments for and against ultimate inflation are both unusually
weighty, and we must decline to choose between them. The
course of the price level since 1933 would seem to belie inflation
fears, but the past is not necessarily conclusive as to the future.
Prudence may suggest some compromise in investment policy,
to include a component of common stocks or tangible assets,
designed to afford some protection against a serious fall in the
dollar’s value. Such a hybrid policy would involve difficult
problems of its own; and in the last analysis each investor must
decide for himself which of the alternative risks he would prefer
to run.

B. SPECULATIVE BONDS AND PREFERRED STOCKS

The problems related to this large class of securities are not
inherent in the class itself, but are rather derived from those of
investment bonds and of common stocks, between which they
lie. The broad principles underlying the purchase of speculative
senior issues remain, in our opinion, the same as they always were:
(1) A risk of principal loss may not be offset by a higher yield
alone but must be accompanied by a commensurate chance of
principal profit; (2) it is generally sounder to approach these
issues as if they were common stocks, but recognizing their
limited claims, than it is to consider them as an inferior type of
senior security.

C. THE PROBLEM OF COMMON-STOCK INVESTMENT

Common-stock speculation, as the term has always been
generally understood, is not so difficult to understand as it is to

INTRODUCTION

practice successfully. The speculator admittedly risks his
money upon his guess or judgment as to the general market or
the action of a particular stock or possibly on some future devel¬
opment in the company's affairs. No doubt the speculator's
problems have changed somewhat with the years, but we incline
to the view that the qualities and training necessary for success,
as well as the mathematical odds against him, are not vitally
different now from what they were before. But stock specula¬
tion, as such, does not come within the scope of this volume.

Current Practice.—We are concerned, however, with common-
stock investment , which we shall define provisionally as purchases
based upon analysis of value and controlled by definite standards
of safety of principal. If we look to current practice to discern
what these standards are, we find little beyond the rather
indefinite concept that “a good stock is a good investment."
“Good" stocks are those of either (1) leading companies with
satisfactory records, a combination relied on to produce favorable
results in the future; or (2) any well-financed enterprise believed
to have especially attractive prospects of increased future
earnings. (As of early 1940, we may cite Coca-Cola as an
example of (1), Abbott Laboratories as an example of (2) and
General Electric as an example of both.)

But although the stock market has very definite and apparently
logical ideas as to the quality of the common stocks that it buys
for investment, its quantitative standards—governing the rela¬
tion of price to determinable value—are so indefinite as to be
almost nonexistent. Balance-sheet values are considered to be
entirely out of the picture. Average earnings have little sig¬
nificance when there is a marked trend. The so-called “price-
earnings ratio" is applied variously, sometimes to the past,
sometimes to the present, and sometimes to the near future.
But the ratio itself can scarcely be called a standard, since it is
controlled by investment practice instead of controlling it.
In other words the “right" price-earnings ratio for any stock is
what the market says it is. We can find no evidence that at any
time from 1926 to date common-stock investors as a class have
sold their holdings because the price-earnings ratios were too
high.

How the present practice of common-stock investors, including
the investment trusts almost without exception, can properly be

SECURITY ANALYSIS

termed investment , in view of this virtual absence of controlling
standards, is more than we can fathom. It would be far more
logical and helpful to call it “ speculation in stocks of strong
companies.” Certainly the results in the stock market of such
“investment” have been indistinguishable from those of old-time
speculation, except perhaps for the margin element. A striking
confirmation of this statement, as applied to the years after the
1929 crash, is found by comparing the price range of General
Electric since 1930 with that of common stocks generally. The
attached figures show that General Electric common, which is
perhaps the premier and undoubtedly the longest entrenched
investment issue in the industrial field today, has fluctuated more
widely in market price than have the rank and file of common
stocks.

Price Ranges of General Electric Common, Dow-Jones Industrials
and Standard Statistics' Industrial Stock Index, 1930-1939

Year

General Electric

Dow-Jones

Industrials

Standard Statistics
Industrials 1

High

Low

High

Low

High

Low

1930

95%

41%

294.1

157.5

174.1

98.2

1931

54%

22%

194.4

73.8

119.1

48.5

1932

26%

88.8

41.2

63.5

30.7

1933

10%

59.2

92.2

36.5

1934

25%

16%

93.3

69.3

1935

40%

20%

148.4

96.7

113.2

72 8

1936

34%

184.9

143.1

148.5

109.1

1937

64%

194.4

158.7

84.2

1938

27%

158.4

WBM

119 3

73.5

1939

44%

155.9

121.4

118.3

86.7

i Weekly indexes of prices (1926 - 100) of 350 industrial issues in 1939 and 347 issues in
earlier years.

It was little short of nonsense for the stock market to say in
1937 that General Electric Company was worth $1,870,000,000
and almost precisely a year later that it was worth only $784,-
000,000. Certainly nothing had happened within twelve months’
time to destroy more than half the value of this powerful enter¬
prise, nor did investors even pretend to claim that the falling off
in earnings from 1937 to 1938 had any permanent significance

INTRODUCTION

for the future of the company. General Electric sold at 64%
because the public was in an optimistic frame of mind and at
27% because the same people were pessimistic. To speak
of these prices as representing “ investment values” or the
“appraisal of investors” is to do violence either to the English
language or to common sense, or both.

Four Problems.—Assuming that a common-stock buyer were
to seek definite investment standards by which to guide his
operations, he might well direct his attention to four questions:
(1) the general future of corporation profits, (2) the differential
in quality between one type of company and another, (3) the
influence of interest rates on the dividends or earnings return
that he should demand, and finally (4) the extent to which his
purchases and sales should be governed by the factor of timing
as distinct from price.

The General Future of Corporate Profits .—If we study these
questions in the light of past experience, our most pronounced
reaction is likely to be a wholesome scepticism as to the soundness
of the stock market's judgment on all broad matters relating
to the future. The data in our first table show quite clearly
that the market underestimated the attractiveness of industrial
common stocks as a whole in the years prior to 1926. Their
prices generally represented a rather cautious appraisal of past
and current earnings, with no signs of any premium being
paid for the possibilities of growth inherent in the leading enter¬
prises of a rapidly expanding commonwealth. In 1913 railroad
and traction issues made up the bulk of investment bonds and
stocks. By 1925 a large part of the investment in street railways
had been endangered by the development of the automobile,
but even then there was no disposition to apprehend a similar
threat to the steam railroads.

The widespread recognition of the factor of future growth in
common stocks first asserted itself as a stock-market influence at
a time when in fact the most dynamic factors in our national
expansion (territorial development and rapid accretions of
population) were no longer operative, and our economy was about
to face grave problems of instability arising from these very
checks to the factor of growth. The overvaluations of the new-
era years extended to nearly every issue that had even a short
period of increasing earnings to recommend it, but especial

SECURITY ANALYSIS

favor was accorded the public-utility and chain-store groups.
Even as late as 1931 the high prices paid for these issues showed
no realization of their inherent limitations, just as five years
later the market still failed to appreciate the critical changes
taking place in the position of railroad bonds as well as stocks.

Quality Differentials .—The stock market of 1940 has its well-
defined characteristics, founded chiefly on the experience of the
recent past and on the rather obvious prospects of the future.
The tendency to favor the larger and stronger companies is
perhaps more pronounced than ever. This is supported by the
record since 1929, which indicates, we believe, both better
resistance to depression and a more complete recovery of earning
power in the case of the leading than of the secondary companies.
There is also the usual predilection for certain industrial groups,
including companies of smaller size therein. Most prominent
are the chemical and aviation shares—the former because of
their really remarkable record of growth through research, the
latter because of the great influx of armament orders.

But these preferences of the current stock market, although
easily understood, may raise some questions in the minds of the
sceptical. First to be considered is the extraordinary disparity
between the prices of prominent and less popular issues. If
average earnings of 1934-9 are taken as a criterion, the “good
stocks” would appear to be selling about two to three times as
high as other issues. In terms of asset values the divergence is
far greater, since obviously the popular issues have' earned a
much larger return on their invested capital. The ignoring of
asset values has reached a stage where even current assets
receive very little attention, so that even a moderately successful
enterprise is likely to be selling at considerably less than its
liquidating value if it happens to be rich in working capital.

The relationship between “good stocks” and other stocks
must be considered in the light of what is to be expected of
American business generally. Any prediction on the latter
point would be highly imprudent; but it is in order to point out
that the record of the last fifteen years does not in itself supply
the basis for an expectation of a long-term upward movement in
volume and profits. In so far as we judge the future by the
past we must recognize a rather complete transformation in the
apparent outlook of 1940 against that in 1924. In the earlier
year a secular rise in production and a steady advance in the

INTRODUCTION

figure taken as “normal” were accepted as a matter of course.
But so far as we can see now, the 1923”1925 average of industrial
production, formerly taken as 100 on the Federal Reserve Boards
index, 1 must still be considered as high a normal as we have any
right to prognosticate. Needless to say, the investor will not
deny the possibility of a renewed secular rise, but the important
point for him is that he cannot count upon it.

If this is the working hypothesis of the present stock market,
it follows that stock buyers are expecting in general a further
growth in the earnings of large companies at the expense of
smaller ones and of favorably situated industries at the expense
of all others. Such an expectation appears to be the theoretical
basis for the high price of the one group and the low prices found
elsewhere. That stocks with good past trends and favorable
prospects are worth more than others goes without saying.
But is it not possible that Wall Street has carried its partiality
too far—in this as in so many other cases? May not the typical
large and prosperous company be subject to a twofold limitation:
first, that its very size precludes spectacular further growth;
second, that its high rate of earnings on invested capital makes it
vulnerable to attack if not by competition then perhaps by
regulation?

Perhaps, also, the smaller companies and the less popular
industries as a class may be definitely undervalued, both abso¬
lutely and in relation to the favored issues. Surely this can be
true in theory, since at some price level the good stocks must
turn out to have been selling too high and the others too low.
There are strong, if not conclusive, reasons for arguing that this
point may have already been reached in 1940. The two possible
points of weakness in the “good stocks” are paralleled by cor¬
responding favorable possibilities in the others. The numerous
issues selling below net current asset value, even in normal
markets, are a powerful indication that Wall Street’s favoritism
has been overdone. Finally, if we carry the analysis further,
we must realize that the smaller listed companies are repre¬
sentative of the hundreds of thousands of private enterprises,
of all sizes, throughout the country. Wall Street is apparently
predicting the continued decline of all business except the very
largest, which is to flourish mightily. In our own opinion such

1 In 1940 the Board revised this index. New components were added and
the average of 1935-1939 was adopted as the base.

SECURITY ANALYSIS

a development appears neither economically probable nor
politically possible.

Similar doubts may be voiced as to the stock market's emphasis
on certain favored industries. This is something that, by the
nature of the case, must always be overdone—since there are
no quantitative checks on the public's enthusiasm for what it
likes. Not only has the market invariably carried its optimism
too far, but it has shown a surprising aptitude for favoring
industries that soon turned out to be facing adverse develop¬
ments. (Witness the baking stocks in 1925, the radio and
refrigeration issues in 1927, the public utility and chain stores
in 1928-29, the liquor issues in 1933.) It is interesting to
compare the “ investor's" eagerness to buy Abbott Laboratories
in 1939 and his comparative indifference to American Home
Products—the one kind of pharmaceutical company being
thought to have brilliant, and the other to have only mediocre,
prospects in store. This distinction may prove to have been
soundly and shrewdly drawn; but the student who remembers
the market's not so remote enthusiasm for American Home
Products itself and its companions (particularly Lambert) in
1927 can hardly be too confident of the outcome. 1

Interest Rates .—Coming now to the third point of importance,
viz., the relation between interest rates and common-stock
prices, it is clear that if current low bond yields are permanent,
they must produce a corresponding decline in average stock
yields and an advance in the value of a dollar of expected earning
power, as compared with the situation, say, in 1923-1925. The
more liberal valuation of earnings in 1936-1938, as shown by the
data relating to the Dow-Jones Industrial Average on page 2,
would thus appear to have been justified by the change in the
long-term interest rate. The disconcerting question presents
itself, however, whether or not the fall in interest rates is not
closely bound up with the cessation of the secular expansion of
business and with a decline in the average profitability of invested
capital. If this is so, the debit factors in stock values generally
may outweigh the credit influence of low interest rates, and a
typical dollar of earning power in 1936-1938 may not really have

1 Data relating to these three companies are given in Appendix Note 1,
p. 729.

INTRODUCTION

been worth more than it should have been worth a decade and a
half previously.

The Factor of Timing .—Increasing importance has been
ascribed in recent years to thp desirability of buying and selling
at the right time, as distinguished from the right price. In
earlier periods, when the prices of investment issues did not
usually fluctuate over a wide range, the time of purchase was not
considered of particular importance. Between 1924 and 1929,
a comfortable but quite misleading confidence developed in
the unlimited future growth of sound stocks, so that any mistake
in timing was sure to be rectified by the market’s recovery to
ever higher levels. The past decade has witnessed very wide
fluctuations without a long-term upward trend, except in a
relatively small number of issues. Under these conditions it is
not surprising that successful investment seems, like successful
speculation, to be bound up inescapably with the choice of the
right moment to buy and to sell. We thus find that forecasting
of the major market swings appears now to be an integral part
of the art of investment in common stocks.

The validity of stock-market forecasting methods is a subject
for extensive inquiry and perhaps vigorous controversy. At this
point we must content ourselves with a summary judgment,
which may reflect our own prejudices along with our investiga¬
tions. It is our view that stock-market timing cannot be done,
with general success, unless the time to buy is related to an
attractive price level, as measured by analytical standards.
Similarly, the investor must take his cue to sell primarily not
from so-called technical market signals but from an advance
in the price level beyond a point justified by objective standards
of value. It may be that within these paramount limits there
are refinements of stock-market technique that can make for
better timing and more satisfactory over-all results. Yet we
cannot avoid the conclusion that the most generally accepted
principle of timing— viz., that purchases should be made only
after an upswing has definitely announced itself—is basically
opposed to the essential nature of investment. Traditionally
the investor has been the man with patience and the courage of
his convictions who would buy when the harried or disheartened
speculator was selling. If the investor is now to hold back until
the market itself encourages him, how will he distinguish himself

SECURITY ANALYSIS

from the speculator, and wherein will he deserve any better than
the ordinary speculator’s fate?

Conclusion. —Our search for definite investment standards
for the common-stock buyer has been more productive of warn¬
ings than of concrete suggestions. We have been led to the old
principle that the investor should wait for periods of depressed
business and market levels to buy representative common stocks,
since he is unlikely to be able to acquire them at other times
except at prices that the future may cause him to regret. On
the other hand, the thousands of so-called secondary companies
should offer at least a moderate number of true investment
opportunities under all conditions, except perhaps in the heydey
of a bull market. This wide but quite unpopular field may
present the more logical challenge to the interest of the bona
fide investor and to the talents of the securities analyst.

PART I

SURVEY AND APPROACH

CHAPTER I

THE SCOPE AND LIMITATIONS OF SECURITY ANALYSIS.

THE CONCEPT OF INTRINSIC VALUE

Analysis connotes the careful study of available facts with the
attempt to draw conclusions therefrom based on established
principles and sound logic. It is part of the scientific method.
But in applying analysis to the field of securities we encounter
the serious obstacle that investment is by nature not an exact
science. The same is true, however, of law and medicine, for
here also both individual skill (art) and chance are important
factors in determining success or failure. Nevertheless, in
these professions analysis is not only useful but indispensable,
so that the same should probably be true in the field of invest¬
ment and possibly in that of speculation.

In the last three decades the prestige of security analysis in
Wall Street has experienced both a brilliant rise and an igno¬
minious fall—a history related but by no means parallel to the
course of stock prices. The advance of security analysis pro¬
ceeded uninterruptedly until about 1927, covering a long period
in which increasing attention was paid on all sides to financial
reports and statistical data. But the “new era” commencing in
1927 involved at bottom the abandonment of the analytical
approach; and while emphasis was still seemingly placed on
facts and figures, these were manipulated by a sort of pseudo¬
analysis to support the delusions of the period. The market
collapse in October 1929 was no surprise to such analysts as
had kept their heads, but the extent of the business collapse which
later developed, with its devastating effects on established earning
power, again threw their calculations out of gear. Hence the
ultimate result was that serious analysis suffered a double

SECURITY ANALYSIS

discrediting: the first—prior to the crash—due to the persistence
of imaginary values, and the second—after the crash—due to the
disappearance of real values.

The experiences of 1927-1933 were of so extraordinary a
character that they scarcely provide a valid criterion for judging
the usefulness of security analysis. As to the years since 1933,
there is perhaps room for a difference of opinion. In the field of
bonds and preferred stocks, we believe that sound principles of
selection and rejection have justified themselves quite well.
In the common-stock arena the partialities of the market have
tended to confound the conservative viewpoint, and conversely
many issues appearing cheap under analysis have given a disap¬
pointing performance. On the other hand, the analytical
approach would have given strong grounds for believing repre¬
sentative stock prices to be too high in early 1937 and too low
a year later.

THREE FUNCTIONS OF ANALYSIS: 1. DESCRIPTIVE FUNCTION

The functions of security analysis may be described under
three headings: descriptive, selective, and critical. In its more
obvious form, descriptive analysis consists of marshalling the
important facts relating to an issue and presenting them in a
coherent, readily intelligible manner. This function is ade¬
quately performed for the entire range of marketable corporate
securities by the various manuals, the Standard Statistics and
Fitch services, and others. A more penetrating type of descrip¬
tion seeks to reveal the strong and weak points in the position
of an issue, compare its exhibit with that of others of similar
character, and appraise the factors which are likely to influence
its future performance. Analysis of this kind is applicable to
almost every corporate issue, and it may be regarded as an
adjunct not only to investment but also to intelligent speculation
in that it provides an organized factual basis for the application
of judgment.

2. THE SELECTIVE FUNCTION OF SECURITY ANALYSIS

In its selective function, security analysis goes further and
expresses specific judgments of its own. It seeks to determine
whether a given issue should be bought, sold, retained, or
exchanged for some other. What types of securities or situations

SURVEY AND APPROACH

lend themselves best to this more positive activity of the analyst,
and to what handicaps or limitations is it subject? It may be
well to start with a group of examples of analytical judgments,
which could later serve as a basis for a more general inquiry.

Examples of Analytical Judgments. —In 1928 the public was
offered a large issue of 6% noncumulative preferred stock of
St. Louis-San Francisco Railway Company priced at 100. The
record showed that in no year in the company's history had
earnings been equivalent to as much as 1^2 times the fixed charges
and preferred dividends combined. The application of well-
established standards of selection to the facts in this case would
have led to the rejection of the issue as insufficiently protected.

A contrasting example: In June 1932 it was possible to purchase
5% bonds of Owens-Illinois Glass Company, due 1939, at 70,
yielding 11% to maturity. The company's earnings were many
times the interest requirements—not only on the average but
even at that time of severe depression. The bond issue was
amply covered by current assets alone, and it was followed by
common and preferred stock with a very large aggregate market
value, taking their lowest quotations. Here, analysis would have
led to the recommendation of this issue as a strongly entrenched
and attractively priced investment.

Let us take an example from the field of common stocks. In
1922, prior to the boom in aviation securities, Wright Aero¬
nautical Corporation stock was selling on the New York Stock
Exchange at only $8, although it was paying a $1 dividend, had
for some time been earning over $2 a share, and showed more
than $8 per share in cash assets in the treasury. In this case
analysis would readily have established that the intrinsic value
of the issue was substantially above the market price.

Again, consider the same issue in 1928 when it had advanced
to $280 per share. It was then earning at the rate of $8 per
share, as against $3.77 in 1927. The dividend rate was $2; the
net-asset value was less than $50 per share. A study of this
picture must have shown conclusively that the market price
represented for the most part the capitalization of entirely con¬
jectural future prospects—in other words, that the intrinsic value
was far less than the market quotation.

A third kind of analytical conclusion may be illustrated by a
comparison of Interborough Rapid Transit Company First and

SECURITY ANALYSIS

Refunding 5s with the same company’s Collateral 7% Notes,
when both issues were selling at the same price (say 62) in 1933.
The 7% notes were clearly worth considerably more than the
5s. Each $1,000 note was secured by deposit of $1,736 face
amount of 5s; the principal of the notes had matured; they were
entitled either to be paid off in full or to a sale of the collateral for
their benefit. The annual interest received on the collateral was
equal to about $87 on each 7 % note (which amount was actually
being distributed to the note holders), so that the current income
on the 7s was considerably greater than that on the 5s. What¬
ever technicalities might be invoked to prevent the note holders
from asserting their contractual rights promptly and completely,
it was difficult to imagine conditions under which the 7s would
not be intrinsically worth considerably more than the 5s.

A more recent comparison of the same general type could have
been drawn between Paramount Pictures First Convertible
Preferred selling at 113 in October 1936 and the common stock
concurrently selling at 15%. The preferred stock was con¬
vertible at the holders’ option into seven times as many shares of
common, and it carried accumulated dividends of about $11 per
share. Obviously the preferred was cheaper than the common,
since it would have to receive very substantial dividends before
the common received anything, and it could also share fully in
any rise of the common by reason of the conversion privilege. If
a common stockholder had accepted this analysis and exchanged
his shares for one-seventh as many preferred, he would soon have
realized a large gain both in dividends received and in principal
value. 1

Intrinsic Value vs. Price.—From the foregoing examples it will
be seen that the work of the securities analyst is not without
concrete results of considerable practical value, and that it is
applicable to a wide variety of situations. In all of these
instances he appears to be concerned with the intrinsic value of
the security and more particularly with the discovery of dis¬
crepancies between the intrinsic value and the market price.
We must recognize, however, that intrinsic value is an elusive
concept. In general terms it is understood to be that value
which is justified by*the facts, e.g ., the assets, earnings, dividends,

1 For the sequels to the six examples just given, see Appendix Note 2,
p. 730.

SURVEY AND APPROACH

definite prospects, as distinct, let us say, from market quotations
established by artificial manipulation or distorted by psy¬
chological excesses. But it is a great mistake to imagine that
intrinsic value is as definite and as determinable as is the market
price. Some time ago intrinsic value (in the case of a common
stock) was thought to be about the same thing as “book value,”
i.e., it was equal to the net assets of the business, fairly priced.
This view of intrinsic value was quite definite, but it proved
almost worthless as a practical matter because neither the average
earnings nor the average market price evinced any tendency to
be governed by the book value.

Intrinsic Value and “Earning Power.”—Hence this idea was
superseded by a newer view, viz., that the intrinsic value of a
business was determined by its earning power. But the phrase
“earning power” must imply a fairly confident expectation of
certain future results. It is not sufficient to know what the past
earnings have averaged, or even that they disclose a definite line
of growth or decline. There must be plausible grounds for
believing that this average or this trend is a dependable guide
to the future. Experience has shown only too forcibly that in
many instances this is far from true. This means that the con¬
cept of “earning power,” expressed as a definite figure, and the
derived concept of intrinsic value, as something equally definite
and ascertainable, cannot be safely accepted as a general premise
of security analysis.

Example: To make this reasoning clearer, let us consider a
concrete and typical example. What would we mean by the
intrinsic value of J. I. Case Company common, as analyzed, say,
early in 1933? The market price was $30; the asset value per
share was $176; no dividend was being paid; the average earnings
for ten years had been $9.50 per share; the results for 1932 had
shown a deficit of $17 per share. If we followed a customary
method of appraisal, we might take the average earnings per
share of common for ten years, multiply this average by ten, and
arrive at an intrinsic value of $95. But let us examine the
individual figures which make up this ten-year average. They
are as shown in the table on page 22. The average of $9.50 is
obviously nothing more than an arithmetical resultant from 10
unrelated figures. It can hardly be urged that this average is
in any way representative of typical conditions in the past or

SECURITY ANALYSIS

representative of what may be expected in the future. Hence
any figure of “real” or intrinsic value derived from this average
must be characterized as equally accidental or artificial. 1
Eabningb feb Siiabe of I. J. Case Common

1932

$17. md)

1931

t. 90(d)

1930

11.00

1929

20.40

1928

26.90

1927

26.00

1926

23.30

1925

15.30

1924

6.90(d)

1923

S 10(d)

Average. $ 9.50

( d ) Deficit.

The Role of Intrinsic Value in the Work of the Analyst.—Let

us try to formulate a statement of the role of intrinsic value in the
work of the analyst which will reconcile the rather conflicting
implications of our various examples. The essential point is
that security analysis does not seek to determine exactly what is
the intrinsic value of a given security. It needs only to establish
either that the value is adequate — e.g. } to protect a bond or to
justify a stock purchase—or else that the value is considerably
higher or considerably lower than the market price. For such
purposes an indefinite and approximate measure of the intrinsic
value may be sufficient. To use a homely simile, it is quite
possible to decide by inspection that a woman is old enough to
vote without knowing her age or that a man is heavier than he
should be without knowing his exact weight.

This statement of the case may be made clearer by a brief
return to our examples. The rejection of St. Louis-San Francisco
Preferred did not require an exact calculation of the intrinsic
value of this railroad system. It was enough to show, very
simply from the earnings record, that the margin of value above
the bondholders' and preferred stockholders' claims was too
small to assure safety. Exactly the opposite was true for the
Owens-Illinois Glass.Ss. In this instance, also, it would undoubt-

1 Between 1933 and 1939 the earnings on Case common varied between
a deficit of $14.66 and profits of $19.20 per share, averaging $3.18. The
price ranged between 30% and 191%, closing in 1939 at 73%.

SURVEY AND APPROACH

edly have been difficult to arrive at a fair valuation of the
business; but it was quite easy to decide that this value in any
event was far in excess of the company’s debt.

In the Wright Aeronautical example, the earlier situation
presented a set of facts which demonstrated that the business was
worth substantially more than $8 per share, or $1,800,000.
In the later year, the facts were equally conclusive that the busi¬
ness did not have a reasonable value of $280 per share, or $70,-
000,000 in all. It would have been difficult for the analyst to
determine whether Wright Aeronautical was actually worth
$20 or $40 a share in 1922—or actually worth $50 or $80 in 1929.
But fortunately it was not necessary to decide these points in
order to conclude that the shares were attractive at $8 and
unattractive, intrinsically, at $280.

The J. I. Case example illustrates the far more typical common-
stock situation, in which the analyst cannot reach a dependable
conclusion as to the relation of intrinsic value to market price.
But even here, if the price had been low or high enough , a con¬
clusion might have been warranted. To express the uncertainty
of the picture, we might say that it was difficult to determine in
early 1933 whether the intrinsic value of Case common was
nearer $30 or $130. Yet if the stock had been selling at as
low as $10, the analyst would undoubtedly have been justified in
declaring that it was worth more than the market price.

Flexibility of the Concept of Intrinsic Value.—This should
indicate how flexible is the concept of intrinsic value as applied
to security analysis. Our notion of the intrinsic value may be
more or less distinct, depending on the particular case. The
degree of indistinctness may be expressed by a very hypothetical
“range of approximate value,” which would grow wider as the
uncertainty of the picture increased, e.g. } $20 to $40 for Wright
Aeronautical in 1922 as against $30 to $130 for Case in 1933. It
would follow that even a very indefinite idea of the intrinsic
value may still justify a conclusion if the current price falls far
outside either the maximum or minimum appraisal.

More Definite Concept in Special Cases.—The Interborough
Rapid Transit example permits a more precise line of reasoning
than any of the others. Here a given market price for the 5%
bonds results in a very definite valuation for the 7 % notes. If it
were certain that the collateral securing the notes would be

SECURITY ANALYSIS

acquired for and distributed to the note holders, than the mathe¬
matical relationship— viz., $1,736 of value for the 7s against
$1,000 of value for the 5s—would eventually be established
at this ratio in the market. But because of quasi-political
complications in the picture, this normal procedure could not be
expected with certainty. As a practical matter, therefore, it is
not possible to say that the 7s are actually worth 74% more than
the 5s, but it may be said with assurance that the 7s are worth
substantially more —which is a very useful conclusion to arrive at
when both issues are selling at the same price.

The Interborough issues are an example of a rather special
group of situations in which analysis may reach more definite
conclusions respecting intrinsic value than in the ordinary case.
These situations may involve a liquidation or give rise to technical
operations known as “arbitrage” or “hedging.” While, viewed
in the abstract, they are probably the most satisfactory field for
the analyst’s work, the fact that they are specialized in character
and of infrequent occurrence makes them relatively unimportant
from the broader standpoint of investment theory and practice.

Principal Obstacles to Success of the Analyst, a. Inadequate
or Incorrect Data .—Needless to say, the analyst cannot be right
all the time. Furthermore, a conclusion may be logically right
but work out badly in practice. The main obstacles to the
success of the analyst’s work are threefold, viz., (1) the inade¬
quacy or incorrectness of the data, (2) the uncertainties of the
future, and (3) the irrational behavior of the market. The first
of these drawbacks, although serious, is the least important of the
three. Deliberate falsification of the data is rare; most of the
misrepresentation flows from the use of accounting artifices
which it is the function of the capable analyst to detect. Con¬
cealment is more common than misstatement. But the extent
of such concealment has been greatly reduced as the result of
regulations, first of the New York Stock Exchange and later
of the S.E.C., requiring more complete disclosure and fuller
explanation of accounting practices. Where information on an
important point is still withheld, the analyst’s experience and
skill should lead him to note this defect and make allowance
therefor—if, indeed, he may not elicit the facts by proper
inquiry and pressure. In some cases, no doubt, the concealment
will elude detection and give rise to an incorrect conclusion.

SURVEY AND APPROACH

b. Uncertainties of the Future .—Of much greater moment is the
element of future change. A conclusion warranted by the facts
and by the apparent prospects may be vitiated by new develop¬
ments. This raises the question of how far it is the function
of security analysis to anticipate changed conditions. We shall
defer consideration of this point until our discussion of various
factors entering into the processes of analysis. It is manifest,
however, that future changes are largely unpredictable, and that
security analysis must ordinarily proceed on the assumption
that the past record affords at least c rough guide to the future.
The more questionable this assumption, the less valuable is the
analysis. Hence this technique is more useful when applied to
senior securities (which are protected against change) than to
common stocks; more useful when applied to a business of inher¬
ently stable character than to one subject to wide variations;
and, finally, more useful when carried on under fairly normal
general conditions than in times of great uncertainty and radical
change.

c. The Irrational Behavior of the Market .—The third handicap
to security analysis is found in the market itself. In a sense the
market and the future present the same kind of difficulties.
Neither can be predicted or controlled by the analyst, yet his
success is largely dependent upon them both. The major
activities of the investment analyst may be thought to have little
or no concern with market prices. His typical function is the
selection of high-grade, fixed-income-bearing bonds, which upon
investigation he judges to be secure as to interest and principal.
The purchaser is supposed to pay no attention to their subsequent
market fluctuations, but to be interested solely in the question
whether the bonds will continue to be sound investments. In
our opinion thi 3 traditional view of the investors attitude is
inaccurate and somewhat hypocritical. Owners of securities,
whatever their character, are interested in their market quota¬
tions. This fact is recognized by the emphasis always laid in
investment practice upon marketability . If it is important that
an issue be readily salable, it is still more important that it
command a satisfactory price. While for obvious reasons the
investor in high-grade bonds has a lesser concern with market
fluctuations than has the speculator, they still have a strong
psychological, if not financial, effect upon him. Even in this

SECURITY ANALYSIS

field, therefore, the analyst must take into account whatever
influences may adversely govern the market price, as well as
those which bear upon the basic safety of the issue.

In that portion of the analyst's activities which relates to the
discovery of undervalued, and possibly of overvalued securities,
he is more directly concerned with market prices. For here the
vindication of his judgment must be found largely in the ultimate
market action of the issue. This field of analytical work may
be said to rest upon a twofold assumption: first, that the market
price is frequently out of line with the true value; and, second,
that there is an inherent tendency for these disparities to correct
themselves. As to the truth of the former statement, there can
be very little doubt—even though Wall Street often speaks
glibly of the “infallible judgment of the market” and asserts that
“a stock is worth what you can sell it for—neither more nor less.”

The Hazard of Tardy Adjustment of Price Value.—The
second assumption is equally true in theory, but its working out
in practice is often most unsatisfactory. Undervaluations
caused by neglect or prejudice may persist for an inconveniently
long time, and the same applies to inflated prices caused by
overenthusiasm or artificial stimulants. The particular danger
to the analyst is that, because of such delay, new determining
factors may supervene before the market price adjusts itself to
the value as he found it. In other words, by the time the price
finally does reflect the value, this value may have changed con¬
siderably and the facts and reasoning on which his decision was
based may no longer be applicable.

The analyst must seek to guard himself against this danger as
best he can: in part, by dealing with those situations preferably
which are not subject to sudden change; in part, by favoring
securities in which the popular interest is keen enough to promise
a fairly swift response to value elements which he is the first
to recognize; in part, by tempering his activities to the general
financial situation—laying more emphasis on the discovery of
undervalued securities when business and market conditions are
on a fairly even keel, and proceeding with greater caution in times
of abnormal stress and uncertainty.

The Relationship of Intrinsic Value to Market Price.—The
general question of the relation of intrinsic value to the market
quotation may be made clearer by the appended chart, which

SURVEY AND APPROACH

traces the various steps
culminating in the market
price. It will be evident
from the chart that the
influence of what we call
analytical factors over the
market price is both par¬
tial and indirect —partial,
because it frequently com¬
petes with purely specula¬
tive factors which influence
the price in the opposite
direction; and indirect,
because it acts through the
intermediary of peopled
sentiments and decisions.
In other words, the market
is not a weighing machine,
on which the value of each
issue is recorded by an
exact and impersonal
mechanism, in accordance
with its specific qualities.
Rather should we say that
the market is a voting
machine, whereon countless
individuals register choices
which are the product
partly of reason and partly
of emotion.

ANALYSIS AND SPECULA¬
TION

It may be thought that
sound analysis should
produce successful results
in any type of situation,
including the confessedly
speculative, i.e,, those sub¬
ject to substantial uncer-

Intrinsic value factors

SECURITY ANALYSIS

tainty and risk. If the selection of speculative issues is based on
expert study of the companies' position, should not this approach
give the purchaser a considerable advantage? Admitting future
events to be uncertain, could not the favorable and unfavorable
developments be counted on to cancel out against each other,
more or less, so that the initial advantage afforded by sound
analysis will carry through into an eventual average profit?
This is a plausible argument but a deceptive one; and its over¬
ready acceptance has done much to lead analysts astray. It is
worth while, therefore, to detail several valid arguments against
placing chief reliance upon analysis in speculative situations.

In the first place, what may be called the mechanics of specula¬
tion involves serious handicaps to the speculator, which may
outweigh the benefits conferred by analytical study. These
disadvantages include the payment of commissions and interest
charges, the so-called “turn of the market" (meaning the spread
between the bid and asked price), and, most important of all, an
inherent tendency for the average loss to exceed the average
profit, unless a certain technique of trading is followed, which
is opposed to the analytical approach.

The second objection is that the underlying analytical factors
in speculative situations are subject to swift and sudden revision.
The danger, already referred to, that the intrinsic value may
change before the market price reflects that value, is therefore
much more serious in speculative than in investment situations.
A third difficulty arises from circumstances surrounding the
unknown factors, which are necessarily left out of security
analysis. Theoretically these unknown factors should have an
equal chance of being favorable or unfavorable, and thus they
should neutralize each other in the long run. For example,
it is often easy to determine by comparative analysis that one
company is selling much lower than another in the same field,
in relation to earnings, although both apparently have similar
prospects. But it may well be that the low price for the appar¬
ently attractive issue is due to certain important unfavorable
factors which, though not disclosed, are known to those identified
with the company—and vice versa for the issue seemingly selling
above its relative value. In speculative situations, those “on
the inside" often have an advantage of this kind which nullifies
ihe premise that good and bad changes in the picture should

SURVEY AND APPROACH

offset each other, and which loads the dice against the analyst
working with some of the facts concealed from him. 1

The Value of Analysis Diminishes as the Element of Chance
Increases. —The final objectiQn is based on more abstract
grounds, but, nevertheless, its practical importance is very great.
Even if we grant that analysis can give the speculator a mathe¬
matical advantage, it does not assure him a profit. His ventures
remain hazardous; in any individual case a loss may be taken;
and after the operation is concluded, it is difficult to determine
whether the analyst’s contribution has been a benefit or a detri¬
ment. Hence the latter’s position in the speculative field is at
best uncertain and somewhat lacking in professional dignity. It
is as though the analyst and Dame Fortune were playing a duet
on the speculative piano, with the fickle goddess calling all the
tunes.

By another and less imaginative simile, we might more con¬
vincingly show why analysis is inherently better suited to invest¬
ment than to speculative situations. (In anticipation of a more
detailed inquiry in a later chapter, we have assumed throughout
this chapter that investment implies expected safety and specula¬
tion connotes acknowledged risk.) In Monte Carlo the odds are
weighted 19 to 18 in favor of the proprietor of the roulette
wheel, so that on the average he wins one dollar out of each 37
wagered by the public. This may suggest the odds against the
untrained investor or speculator. Let us assume that, through
some equivalent of analysis, a roulette player is able to reverse
the odds for a limited number of wagers, so that they are now
18 to 19 in his favor. If he distributes his wagers evenly over
all the numbers, then whichever one turns up he is certain to win
a moderate amount. This operation may be likened to an
investment program based upon sound analysis and carried on
under propitious general conditions.

But if the player wagers all his money on a single number, the
small odds in his favor are of slight importance compared with
the crucial question whether chance will elect the number he has
chosen. His “ analysis” will enable him to win a little more if he
is lucky; it will be of no value when luck is against him. This, in

1 See Appendix Note 3, p. 731, for the result of a study of the market
behavior of “high price-earnings ratio stocks” as compared with “low
price-earnings ratio stocks.”

SECURITY ANALYSIS

slightly exaggerated form perhaps, describes the position of the
analyst dealing with essentially speculative operations. Exactly
the same mathematical advantage which practically assures good
results in the investment field may prove entirely ineffective
where luck is the overshadowing influence.

It would seem prudent, therefore, to consider analysis as an
adjunct or auxiliary rather than as a guide in speculation. It
is only where chance plays a subordinate role that the analyst
can properly speak in an authoritative voice and accept responsi¬
bility for the results of his judgments.

3. THE CRITICAL FUNCTION OF SECURITY ANALYSIS

The principles of investment finance and the methods of
corporation finance fall necessarily within the province of security
analysis. Analytical judgments are reached by applying stand¬
ards to facts. The analyst is concerned, therefore, with the
soundness and practicability of the standards of selection. He
is also interested to see that securities, especially bonds and
preferred stocks, be issued with adequate protective provisions,
and—more important still—that proper methods of enforcement
of these convenants be part of accepted financial practice.

It is a matter of great moment to the analyst that the facts
be fairly presented, and this means that he must be highly
critical of accounting methods. Finally, he must concern
himself with all corporate policies affecting the security owner,
for the value of the issue which he analyzes may be largely
dependent upon the acts of the management. In this category
are included questions of capitalization set-up, of dividend and
expansion policies, of managerial compensation, and even of
continuing or liquidating an unprofitable business.

On these matters of varied import, security analysis may be
competent to express critical judgments, looking to the avoidance
of mistakes, to the correction of abuses, and to the better pro¬
tection of those owning bonds or stocks.

CHAPTER II

FUNDAMENTAL ELEMENTS IN THE PROBLEM OF
ANALYSIS. QUANTITATIVE AND QUALITATIVE
FACTORS

In the previous chapter we referred to some of the concepts
and materials of analysis from the standpoint of their bearing on
what the analyst may hope to accomplish. Let us now imagine
the analyst at work and ask what are the broad considerations
which govern his approach to a particular problem, and also
what should be his general attitude toward the various kinds of
information with which he has to deal.

FOUR FUNDAMENTAL ELEMENTS

The object of security analysis is to answer, or assist in answer¬
ing, certain questions of a very practical nature. Of these,
perhaps the most customary are the following: What securities
should be bought for a given purpose ? Should issue S be bought,
or sold, or retained?

In all such questions, four major factors may be said to enter,
either expressly or by implication. These are:

1. The security.

2. The price.

3. The time.

4. The person.

More completely stated, the second typical question would
run, Should security S be bought (or sold, or retained) at price
P, at this time T, by individual /? Some discussion of the rela¬
tive significance of these four factors is therefore pertinent, and
we shall find it convenient to consider them in inverse order.

The Personal Element. —The personal element enters to a
greater or lesser extent into every security purchase. The aspect
of chief importance is usually the financial position of the intend¬
ing buyer. What might be an attractive speculation for a

SECURITY ANALYSIS

business man should under no circumstances be attempted by a
trustee or a widow with limited income. Again, United States
Liberty 3Ks should not have been purchased by those to whom
their complete tax-exemption feature was of no benefit, when a
considerably higher yield could be obtained from partially
taxable governmental issues. 1

Other personal characteristics that on occasion might properly
influence the individuals choice of securities are his financial
training and competence, his temperament, and his preferences.
But however vital these considerations may prove at times, they
are not ordinarily determining factors in analysis. Most of the
conclusions derived from analysis can be stated in impersonal
terms, as applicable to investors or speculators as a class.

The Time. —The time at which an issue is analyzed may affect
the conclusion in various ways. The company’s showing may be
better, or its outlook may seem better, at one time than another,
and these changing circumstances are bound to exert a varying
influence on the analyst’s viewpoint toward the issue. Further¬
more, securities are selected by the application of standards of
quality and yield, and both of these—particularly the latter—
will vary with financial conditions in general. A railroad bond
of highest grade yielding 5% seemed attractive in June 1931
because the average return on this type of bond was 4.32%.
But the same offering made six months later would have been
quite unattractive, for in the meantime bond prices had fallen
severely and the yield on this group had increased to 5.86%.
Finally, nearly all security commitments are influenced to some
extent by the current view of the financial and business outlook.
In speculative operations these considerations are of controlling
importance; and while conservative investment is ordinarily
supposed to disregard these elements, in times of stress and uncer¬
tainty they may not be ignored.

Security analysis, as a study, must necessarily concern itself
as much as possible with principles and methods which are valid
at all times—or, at least, under all ordinary conditions. It
should be kept in mind, however, that the practical applications
of analysis are made against a background largely colored by
the changing times.

1 In 1927 the yield on these 3Hs was 3.39%, while U. 8 . Liberty 4}^s, due
about the same time, were yielding 4.08%.

SURVEY AND APPROACH

The Price. —The price is an integral part of every complete
judgment relating to securities. In the selection of prime
investment bonds, the price is usually a subordinate factor, not
because it is a matter of indifference but because in actual prac¬
tice the price is rarely unreasonably high. Hence almost entire
emphasis is placed on the question whether the issue is adequately
secured. But in a special case, such as the purchase of high-
grade convertible bonds, the price may be a factor fully as impor¬
tant as the degree of security. This point is illustrated by the
American Telephone and Telegraph Company Convertible 4J^s,
due 1939, which sold above 200 in 1929. The fact that principal
(at par) and interest were safe beyond question did not prevent
the issue from being an extremely risky purchase at that price —
one which in fact was followed by the loss of over half its market
value. 1

In the field of common stocks, the necessity of taking price
into account is more compelling, because the danger of paying
the wrong price is almost as great as that of buying the wrong
issue. We shall point out later that the new-era theory of invest¬
ment left price out of the reckoning, and that this omission was
productive of most disastrous consequences.

The Security: Character of the Enterprise and the Terms of
the Commitment. —The roles played by the security and its price
in an investment decision may be set forth more clearly if we
restate the problem in somewhat different form. Instead of
asking, (1) In what security? and (2) At what price? let us ask,
(1) In what enterprise? and (2) On what terms is the commitment
proposed? This gives us a more comprehensive and evenly
balanced contrast between two basic elements in analysis. By
the terms of the investment or speculation, we mean not only the
price but also the provisions of the issue and its status or showing
at the time.

1 Annual price ranges for American Telephone and Telegraph Com¬
pany Convertible 4^8, due in 1939, were as follows:

Year

High

Low

1929

227

118

1930

193 H

110

1931

135

SECURITY ANALYSIS

Example of Commitment on Unattractive Terms. —An invest¬
ment in the soundest type of enterprise may be made on unsound
and unfavorable terms. Prior to 1929 the value of urban real
estate had tended to grow steadily over a long period of years;
hence it came to be regarded by many as the “ safest ” medium of
investment. But the purchase of a preferred stock in a New
York City real estate development in 1929 might have involved
terms of investment so thoroughly disadvantageous as to banish
all elements of soundness from the proposition. One such stock
offering could be summarized as follows 1 :

1. Provisions of the Issue .—A preferred stock, ranking junior
to a large first mortgage and without unqualified rights to
dividend or principal payments. It ranked ahead of a common
stock which represented no cash investment so that the common
stockholders had nothing to lose and a great deal to gain, while
the preferred stockholders had everything to lose and only a
small share in the possible gain.

2. Status of the Issue .—A commitment in a new building, con¬
structed at an exceedingly high level of costs, with no reserves or
junior capital to fall back upon in case of trouble.

3. Price of the Issue. —At par the dividend return was 6%,
which was much less than the yield obtainable on real-estate
second mortgages having many other advantages over this
preferred stock. 2

Example of a Commitment on Attractive Terms. —We have

only to examine electric power and light financing in recent years

ir The financing method described is that used by the separate owning
corporations organized and sponsored by the Fred F. French Company and
affiliated enterprises, with the exception of some of the later Tudor City
units in the financing of which interest-bearing notes, convertible par for
par into preferred stock at the option of the company, were substituted for
the preferred stock in the financial plan. See The French Plan (10th ed.,
December 1928) published and distributed by the Fred F. French Investing
Company, Inc. See also Moody's Manual; “Banks and Finance,” 1933,
pp. 1703-1707.

* The real-estate enterprise from which this example is taken gave a bonus
of common stock with the preferred shares. The common stock had no
immediate value, but it did have a potential value which, under favorable
conditions , might have made the purchase profitable. From the investment
standpoint, however, the preferred stock of this enterprise was subject to
all of the objections which we have detailed. Needless to say, purchasers
of these issues fared very badly in nearly every case.

SURVEY AND APPROACH

to find countless examples of unsound securities in a funda¬
mentally attractive industry. By way of contrast let us cite
the case of Brooklyn Union Elevated Railroad First 5s, due 1950,
which sold in 1932 at 60 to-yield 9.85% to maturity. They
are an obligation of the Brooklyn-Manhattan Transit System.
The traction, or electric railway, industry has long been unfavor¬
ably regarded, chiefly because of automobile competition but also
on account of regulation and fare-contract difficulties. Hence
this security represents a comparatively unattractive type of
enterprise. Yet the terms of the investment here might well
make it a satisfactory commitment, as shown by the following:

1. Provisions of the Issue .—By contract between the operating
company and the City of New York, this was a first charge on the
earnings of the combined subway and elevated lines of the system,
both company and city owned, representing an investment
enormously greater than the size of this issue.

2. Status of the Issue .—Apart from the very exceptional
specific protection just described, the bonds were obligations of
a company with stable and apparently fully adequate earning
power.

3. Price of Issue. —It could be purchased to yield somewhat
more than the Brooklyn-Manhattan Transit Corporation 6s, due
1968, which occupied a subordinate position. (At the low price
of 68 for the latter issue in 1932 its yield was 9% against 9.85%
for the Brooklyn Union Elevated 5s. 1 )

Relative Importance of the Terms of the Commitment and the
Character of the Enterprise.—Our distinction between the char¬
acter of the enterprise and the terms of the commitment suggests
a question as to which element is the more important. Is it
better to invest in an attractive enterprise on unattractive terms
or in an unattractive enterprise on attractive terms? The
popular view unhesitatingly prefers the former alternative, and
in so doing it is instinctively, rather than logically, right. Over a
long period, experience will undoubtedly show that less money
has been lost by the great body of investors through paying too

1 By 1936 the price of the Brooklyn Union Elevated 5s had advanced
to 116H- After 1937 the earnings of the B.M.T. declined, and the price
of this issue fell to 69. In the purchase of the system by New York City
in 1940, however, the strong position of this issue was recognized, and it#
price recovered again to 92.

SECURITY ANALYSIS

high a price for securities of the best regarded enterprises than
by trying to secure a larger income or profit from commitments
in enterprises of lower grade.

From the standpoint of analysis, however, this empirical
result does not dispose of the matter. It merely exemplifies a
rule that is applicable to all kinds of merchandise, viz., that the
untrained buyer fares best by purchasing goods of the highest
reputation, even though he may pay a comparatively high price.
But, needless to say, this is not a rule to guide the expert mer¬
chandise buyer, for he is expected to judge quality by examination
and not solely by reputation, and at times he may even sacrifice
certain definite degrees of quality if that which he obtains is
adequate for his purpose and attractive in price. This distinc¬
tion applies as well to the purchase of securities as to buying
paints or watches. It results in two principles of quite opposite
character, the one suitable for the untrained investor, the other
useful only to the analyst.

1. Principle for the untrained security buyer: Do not put money in a low-
grade enterprise on any terms.

2. Principle for the securities analyst: Nearly every issue might conceivably
be cheap in one price range and dear in another.

We have criticized the placing of exclusive emphasis on the
choice of the enterprise on the ground that it often leads to
paying too high a price for a good security. A second objection
is that the enterprise itself may prove to be unwisely chosen. It
is natural and proper to prefer a business which is large and well
managed, has a good record, and is expected to show increasing
earnings in the future. But these expectations, though seemingly
well-founded, often fail to be realized. Many of the leading
enterprises of yesterday are today far back in the ranks. Tomor¬
row is likely to tell a similar story. The most impressive illus¬
tration is afforded by the persistent decline in the relative
investment position of the railroads as a class during the past two
decades. The standing of an enterprise is in part a matter of
fact and in part a matter of opinion. During recent years
investment opinion has proved extraordinarily volatile and
undependable. In 1929 Westinghouse Electric and Manu¬
facturing Company was quite universally considered as enjoying
an unusually favorable industrial position. Two years later
the stock sold for much less than the net current assets alone,

SURVEY AND APPROACH

presumably indicating widespread doubt as to its ability to earn
any profit in the future. Great Atlantic and Pacific Tea Com¬
pany, viewed as little short of a miraculous enterprise in 1929,
declined from 494 in that year to 36 in 1938. At the latter date
the common sold for less than its cash assets, the preferred being
amply covered by other current assets.

These considerations do not gainsay the principle that
untrained investors should confine themselves to the best regarded
enterprises. It should be realized, however, that this preference
is enjoined upon them because of the greater risk for them in
other directions, and not because the most popular issues are
necessarily the safest. The analyst must pay respectful attention
to the judgment of the market place and to the enterprises which
it strongly favors, but he must retain an independent and critical
viewpoint. Nor should he hesitate to condemn the popular
and espouse the unpopular when reasons sufficiently weighty
and convincing are at hand.

QUALITATIVE AND QUANTITATIVE FACTORS IN ANALYSIS

Analyzing a security involves an analysis of the business.
Such a study could be carried to an unlimited degree of detail;
hence practical judgment must be exercised to determine how
far the process should go. The circumstances will naturally
have a bearing on this point. A buyer of a $1,000 bond would
not deem it worth his while to make as thorough an analysis of an
issue as would a large insurance company considering the purchase
of a $500,000 block. The latter’s study would still be less
detailed than that made by the originating bankers. Or, from
another angle, a less intensive analysis should be needed in
selecting a high-grade bond yielding 3% than in trying to find
a well-secured issue yielding 6% or an unquestioned bargain in
the field of common stocks.

Technique and Extent of Analysis Should Be Limited by
Character and Purposes of the Commitment.—The equipment
of the analyst must include a sense of proportion in the use of his
technique. In choosing and dealing with the materials of
analysis he must consider not only inherent importance and
dependability but also the question of accessibility and con¬
venience. He must not be misled by the availability of a mass
of data— e.g. f in the reports of the railroads to the Interstate
Commerce Commission—into making elaborate studies of

SECURITY ANALYSIS

nonessentials. On the other hand, he must frequently resign
himself to the lack of significant information because it can be
secured only by expenditure of more effort than he can spare or
the problem will justify. This would be true frequently of some
of the elements involved in a complete “ business analysis ”—as,
for example, the extent to which an enterprise is dependent upon
patent protection or geographical advantages or favorable labor
conditions which may not endure.

Value of Data Varies with Type of Enterprise.—Most important
of all, the analyst must recognize that the value of a particular
kind of data varies greatly with the type of enterprise which is
being studied. The five-year record of gross or net earnings
of a railroad or a large chain-store enterprise may afford, if not
a conclusive, at least a reasonably sound basis for measuring
the safety of the senior issues and the attractiveness of the com¬
mon shares. But the same statistics supplied by one of the
smaller oil-producing companies may well prove more deceptive
than useful, since they are chiefly the resultant of two factors,
viz., price received and production, both of which are likely to be
radically different in the future than in the past.

Quantitative vs. Qualitative Elements in Analysis.—It is
convenient at times to classify the elements entering into an
analysis under two headings: the quantitative and the qualita¬
tive. The former might be called the company's statistical
exhibit. Included in it would be all the useful items in the
income account and balance sheet, together with such additional
specific data as may be provided with respect to production and
unit prices, costs, capacity, unfilled orders, etc. These various
items may be subclassified under the headings: (1) capitalization,
(2) earnings and dividends, (3) assets and liabilities, and (4)
operating statistics.

The qualitative factors, on the other hand, deal with such
matters as the nature of the business; the relative position of the
individual company in the industry; its physical, geographical,
and operating characteristics; the character of the management;
and, finally, the outlook for the unit, for the industry, andfor busi¬
ness in general. Questions of this sort are not dealt with ordina¬
rily in the company's reports. The analyst must look for their
answers to miscellaneous sources of information of greatly varying
dependability—including a large admixture of mere opinion.

SURVEY AND APPROACH

Broadly speaking, the quantitative factors lend themselves
far better to thoroughgoing analysis than do the qualitative
factors. The former are fewer in number, more easily obtainable,
and much better suited to the forming of definite and dependable
conclusions. Furthermore the financial results will themselves
epitomize many of the qualitative elements, so that a detailed
study of the latter may not add much of importance to the
picture. The typical analysis of a security—as made, say, in
a brokerage-house circular or in a report issued by a statis¬
tical service—will treat the qualitative factors in a super¬
ficial or summary fashion and devote most of its space to the
figures.

Qualitative Factors: Nature of the Business and Its Future
Prospects.—The qualitative factors upon which most stress is
laid are the nature of the business and the character of the man¬
agement. These elements are exceedingly important, but they
are also exceedingly difficult to deal with intelligently. Let us
consider, first, the nature of the business, in which concept is
included the general idea of its future prospects. Most people
have fairly definite notions as to what is “a good business”
and what is not. These views are based partly on the financial
results, partly on knowledge of specific conditions in the industry,
and partly also on surmise or bias.

During most of period of general prosperity between 1923 and
1929, quite a number of major industries were backward. These
included cigars, coal, cotton goods, fertilizers, leather, lumber,
meat packing, paper, shipping, street railways, sugar, woolen
goods. The underlying cause was usually either the develop¬
ment of competitive products or services ( e.g. y coal, cotton goods,
tractions) or excessive production and demoralizing trade
practices ( e.g ., paper, lumber, sugar). During the same period
other industries were far more prosperous than the average.
Among these were can manufacturers, chain stores, cigarette
producers, motion pictures, public utilities. The chief cause
of these superior showings might be found in unusual growth of
demand (cigarettes, motion pictures) or in absence or control of
competition (public utilities, can makers) or in the ability to win
business from other agencies (chain stores).

It is natural to assume that industries which have fared worse
than the average are “unfavorably situated” and therefore to

SECURITY ANALYSIS

be avoided. The converse would be assumed, of course, for
those with superior records. But this conclusion may often
prove quite erroneous. Abnormally good or abnormally bad
conditions do not last forever. This is true not only of general
business but of particular industries as well. Corrective forces
are often set in motion which tend to restore profits where they
have disappeared, or to reduce them where they are excessive in
relation to capital.

Industries especially favored by a developing demand may
become demoralized through a still more rapid growth of supply.
This has been true of radio, aviation, electric refrigeration, bus
transportation, and silk hosiery. In 1922 department stores
were very favorably regarded because of their excellent showing
in the 1920-1921 depression; but they did not maintain this
advantage in subsequent years. The public utilities were
unpopular in the 1919 boom, because of high costs; they became
speculative and investment favorites in 1927-1929; in 1933-1938
fear of inflation, rate regulation and direct governmental com¬
petition again undermined the public’s confidence in them. In
1933, on the other hand, the cotton-goods industry—long
depressed—forged ahead faster than most others.

The Factor of Management. —Our appreciation of the impor¬
tance of selecting a “good industry” must be tempered by a
realization that this is by no means so easy as it sounds. Some¬
what the same difficulty is met with in endeavoring to select an
unusually capable management. Objective tests of managerial
ability are few and far from scientific. In most cases the investor
must rely upon a reputation which may or may not be deserved.
The most convincing proof of capable management lies in a
superior comparative record over a period of time. But this
brings us back to the quantitative data.

There is a strong tendency in the stock market to value the
management factor twice in its calculations. Stock prices reflect
the large earnings which the good management has produced,
plus a substantial increment for “good management” considered
separately. This amounts to “counting the same trick twice”
and it proves a frequent cause of overvaluation.

The Trend of Future Earnings. —In recent years increasing
importance has been laid upon the trend of earnings . Needless
to say, a record of increasing profits is a favorable sign. Finan-

SURVEY AND APPROACH

cial theory has gone further, however, and has sought to estimate
future earnings by projecting the past trend into the future and
then used this projection as a basis for valuing the business.
Because figures are used in this process, people mistakenly
believe that it is “mathematically sound.” But while a trend
shown in the past is a fact, a “future trend” is only an
assumption. The factors that we mentioned previously as
militating against the maintenance of abnormal prosperity or
depression are equally opposed to the indefinite continuance
of an upward or downward trend. By the time the trend has
become clearly noticeable, conditions may well be ripe for a
change.

It may be objected that as far as the future is concerned it is
just as logical to expect a past trend to be maintained as to
expect a past average to be repeated. This is probably true,
but it does not follow that the trend is more useful to analysis
than the individual or average figures of the past. For security
analysis does not assume that a past average will be repeated,
but only that it supplies a rough index to what may be expected
of the future. A trend, however, cannot be used as a rough
index; it represents a definite prediction of either better or
poorer results, and it must be either right or wrong.

This distinction, important in its bearing on the attitude of
the analyst, may be made clearer by the use of examples. Let
us assume that in 1929 a railroad showed its interest charges
earned three times on the average during the preceding seven
years. The analyst would have ascribed great weight to this
point as an indication that its bonds were sound. This is a
judgment based on quantitative data and standards. But it
does not imply a prediction that the earnings in the next seven
years will average three times interest charges; it suggests only
that earnings are not likely to fall so much under three times
interest charges as to endanger the bonds. In nearly every actual
case such a conclusion would have proved correct, despite the
economic collapse that ensued.

Now let us consider a similar judgment based primarily upon
the trend. In 1929 nearly all public-utility systems showed a
continued growth of earnings, but the fixed charges of many were
so heavy—by reason of pyramidal capital structures—that
they consumed nearly all the net income. Investors bought

SECURITY ANALYSIS

bonds of these systems freely on the theory that the small
margin of safety was no drawback, since earnings were certain to
continue to increase. They were thus making a clear-cut pre-
diction as to the future, upon the correctness of which depended
the justification of their investment. If their prediction were
wrong—as proved to be the case—they were bound to suffer
serious loss.

Trend Essentially a Qualitative Factor.—In our discussion of
the valuation of common stocks, later in this book, we shall point
out that the placing of preponderant emphasis on the trend is
likely to result in errors of overvaluation or undervaluation.
This is true because no limit may be fixed on how far ahead the
trend should be projected; and therefore the process of valuation,
while seemingly mathematical, is in reality psychological and
quite arbitrary. For this reason we consider the trend as a
qualitative factor in its practical implications, even though it
may be stated in quantitative terms.

Qualitative Factors Resist Even Reasonably Accurate
Appraisal.—The trend is, in fact, a statement of future pros¬
pects in the form of an exact prediction. In similar fashion,
conclusions as to the nature of the business and the abilities of
the management have their chief significance in their bearing
on the outlook. These qualitative factors arc therefore all of
the same general character. They all involve the same basic
difficulty for the analyst, viz., that it is impossible to judge how
far they may properly reflect themselves in the price of a given
security. In most cases, if they are recognized at all, they tend
to be overemphasized. We see the same influence constantly
at work in the general market. The recurrent excesses of its
advances and declines are due at bottom to the fact that, when
values are determined chiefly by the outlook, the resultant
judgments are not subject to any mathematical controls and
are almost inevitably carried to extremes.

Analysis is concerned primarily with values which are sup¬
ported by the facts and not with those which depend largely upon
expectations. In this respect the analyst’s approach is diamet¬
rically opposed to that of the speculator, meaning thereby one
whose success turns upon his ability to forecast or to guess future
developments. Needless to say, the analyst must take possible
future changes into account, but his primary aim is not so much

SURVEY AND APPROACH

to profit from them as to guard against them. Broadly speaking,
he views the business future as a hazard which his conclusions
must encounter rather than as the source of his vindication.

Inherent Stability a MajorQualitative Factor. —It follows that
the qualitative factor in which the analyst should properly be
most interested is that of inherent stability . For stability means
resistance to change and hence greater dependability for the
results shown in the past. Stability, like the trend, may be
expressed in quantitative terms—as, for example, by stating
that the earnings of General Baking Company during 1923-1932
were never less than ten times 1932 interest charges or that the
operating profits of Woolworth between 1924 and 1933 varied
only between $2.12 and $3.66 per share of common. But in our
opinion stability is really a qualitative trait, because it derives
in the first instance from the character of the business and not
from its statistical record. A stable record suggests that the
business is inherently stable, but this suggestion may be rebutted
by other considerations.

Examples: This point may be brought out by a comparison of
two preferred-stock issues as of early 1932, viz., those of Stude-
baker (motors) and of First National (grocery) Stores, both of
which were selling above par. The two exhibits were similar,
in that both disclosed a continuously satisfactory margin above
preferred-dividend requirements. The Studebaker figures were
more impressive, however, as the following table will indicate:

Number op Times Preferred Dividend Was Covered

First National Stores

Studebaker

Times

Calendar

Times

Period

covered

year

covered

Calendar year, 1922.

4.0

1922

27.3

Calendar year, 1923.

5.1

1923

30.5

Calendar year, 1924.

4.9

1924

23.4

Calendar year, 1925.

5.7

1925

29.7

15 mos. ended Mar. 31, 1927_

4.6

1926

24.8

Year ended Mar. 31, 1928.

4.4

1927

23.0

Year ended Mar. 31, 1929.

8.4

1928

27.3

Year ended Mar. 31, 1930.

13.4

1929

23.3

Annual average.

6.3

26.2

SECURITY ANALYSIS

But the analyst must penetrate beyond the mere figures and
consider the inherent character of the two businesses. The
chain-store grocery trade contained within itself many elements
of relative stability, such as stable demand, diversified loca¬
tions and rapid inventory turnover. A typical large unit in this
field, provided only it abstained from reckless expansion policies,
was not likely to suffer tremendous fluctuations in its earnings
But the situation of the typical automobile manufacturer was
quite different. Despire fair stability in the industry as a whole,
the individual units were subject to extraordinary variations,
due chiefly to the vagaries of popular preference. The stability
of Studebaker’s earnings could not be held by any convincing
logic to demonstrate that this company enjoyed a special and
permanent immunity from the vicissitudes to which most of its
competitors had shown themselves subject. The soundness of
Studebaker Preferred rested, therefore, largely upon a stable
statistical showing which was at variance with the general char¬
acter of the industry, so far as its individual units were con¬
cerned. On the other hand, the satisfactory exhibit of First
National Stores Preferred was in thorough accord with what was
generally thought to be the inherent character of the business.
The latter consideration should have carried great weight with
the analyst and should have made First National Stores Preferred
appear intrinsically sounder as a fixed-value investment than
Studebaker Preferred, despite the more impressive statistical
showing of the automobile company. 1

Summary.—To sum up this discussion of qualitative and quan¬
titative factors, we may express the dictum that the analyst’s
conclusions must always rest upon the figures and upon estab¬
lished tests and standards. These figures alone are not sufficient;
they may be completely vitiated by qualitative considerations
of an opposite import. A security may make a satisfactory sta¬
tistical showing, but doubt as to the future or distrust of the man¬
agement may properly impel its rejection. Again, the analyst
is likely to attach prime importance to the qualitative element
of stability, because its presence means that conclusions based on

1 First National Stores has since maintained its earning power with little
change; the preferred stock was redeemed in 1934 and subsequently.
Studebaker’s earnings fell off sharply after 1930; a receiver was appointed
in 1933; and the preferred stockist nearly all its value.

SURVEY AND APPROACH

past results are not so likely to be upset by unexpected develop¬
ments. It is also true that he will be far more confident in his
selection of an issue if he can buttress an adequate quantitative
exhibit with unusually favorable qualitative factors.

But whenever the commitment depends to a substantial degree
upon these qualitative factors—whenever, that is, the price is
considerably higher than the figures alone would justify—then
the analytical basis of approval is lacking. In the mathematical
phrase, a satisfactory statistical exhibit is a necessary though by
no means a sufficient condition for a favorable decision by the
analyst.

CHAPTER III

SOURCES OF INFORMATION

It is impossible to discuss or even to list all the sources of
information which the analyst may find it profitable to consult
at one time or another in his work. In this chapter we shall
present a concise outline of the more important sources, together
with some critical observations thereon; and we shall also
endeavor to convey, by means of examples, an idea of the
character and utility of the large variety of special avenues of
information.

DATA ON THE TERMS OF THE ISSUE

Let us assume that in the typical case the analyst seeks data
regarding: (1) the terms of the specific issue, (2) the company,
and (3) the industry. The provisions of the issue itself are
summarized in the security manuals or statistical services. For
more detailed information regarding a bond contract the analyst
should consult the indenture (or deed of trust), a copy of which
may be obtained or inspected at the office of the trustee. The
terms of the respective stock issues of a company are set forth
fully in the charter (or articles of incorporation), together with
the by-laws. If the stock is listed, these documents are on file
with the S.E.C. and also with the proper stock exchange. In
the case of both bonds and stocks, the listing applications—
which are readily obtainable—contain nearly all the significant
provisions. Prospectuses of new issues also contain these
provisions.

DATA ON THE COMPANY

Reports to Stockholders (Including Interim News Releases).—

Coming now to the company, the chief source of statistical
data is, of course, the reports issued to the stockholders. These
reports vary widely with respect to both frequency and com¬
pleteness, as the following summary will show:

SURVEY AND APPROACH

All important railroads supply monthly figures down to net after
rentals (net railway operating income). Most carry the results
down to the balance for dividends (net income). Many publish
carloading figures weekly , and-a few have published gross earnings
weekly. The pamphlet annual reports publish financial and
operating figures in considerable detail. 1

The ruling policy of public-utility companies varies between
quarterly and monthly statements. Figures regularly include
gross, net after taxes, and balance for dividends. Some com¬
panies publish only a moving twelve-month total— e.g ., American
Water Works and Electric Company (monthly), North American
Company (quarterly). Many supply weekly or monthly figures
of kilowatt-hours sold.

Industrials. —The practices followed by industrial companies
are usually a matter of individual policy. In some industrial
groups there is a tendency for most of the companies therein to
follow the same course.

1. Monthly Statements. —Most chain stores announce their
monthly sales in dollars. Prior to 1931, copper producers
regularly published their monthly output. General Motors
publishes monthly sales in units.

Between 1902 and 1933, United States Steel Corporation
published its unfilled orders each month, but in 1933 it replaced
this figure by monthly deliveries in tons. Baldwin Locomotive
Works has published monthly figures of shipments, new orders,
and unfilled orders in dollars. The “Standard Oil Group” of pipe¬
line companies publish monthly statistics of operations in barrels.

Monthly figures of net earnings are published by individual
companies from time to time, but such practices have tended to
be sporadic or temporary ( e.g ., Otis Steel, Mullins Manufacturing,
Alaska Juneau). 2 There is a tendency to inaugurate monthly
statements during periods of improvement and to discontinue
them with earnings decline. Sometimes figures by months are

1 Some railroads now send all stockholders a condensed annual statement
but offer to send a more comprehensive report on request.

*The Alaska Juneau figures—somewhat abbreviated—have continued
from about 1925 to the end of 1939. In 1938 Caterpillar Tractor began to
publish monthly a complete income account and a balance sheet. This
is not really so extraordinary, for most companies supply these data to their
directors.

SECURITY ANALYSIS

included in the quarterly statements— e.g., United States Steel
Corporation prior to 1932.

2. Quarterly Statements .—Publication of results quarterly is
considered as the standard procedure in nearly all lines of
industry. The New York Stock Exchange has been urging
quarterly reports with increasing vigor, and has usually been
able to make its demands effective in connection with the
listing of new or additional securities. Certain types of busi¬
nesses are considered—or consider themselves—exempt from
this requirement, because of the seasonal nature of their results.
These lines include sugar production, fertilizers, and agricultural
implements. Seasonal fluctuations may be concealed by pub¬
lishing quarterly a moving twelve-months , figure of earnings.
This is done by Continental Can Company. 1

It is not easy to understand why all the large cigarette manu¬
facturers and the majority of department stores should with¬
hold their results for a full year. It is inconsistent also for a
company such as Wool worth to publish sales monthly but no
interim statements of net profits. Many individual companies,
belonging to practically every division of industry, still fail to
publish quarterly reports. In nearly every case such interim
figures are available to the management but are denied to the
stockholders without adequate reason.

The data given in the quarterly statements vary from a
single figure of net earnings (sometimes without allowance for
depreciation or federal taxes) to a fully detailed presentation
of the income account and the balance sheet, with president's
remarks appended. General Motors Corporation is an out¬
standing example of the latter practice.

3. Semiannual Reports .—These do not appear to be standard
practice for any industrial group, except possibly the rubber
companies. A number of individual enterprises report semi¬
annually— e.g., American Locomotive and American Woolen.

4. Annual Reports .—Every listed company publishes an
annual report of some kind. The annual statement is generally
more detailed than those covering interim periods. It frequently

1 In March 1936 the New York Stock Exchange suggested that all listed
companies follow this procedure instead of publishing the usual quarterly
earnings. This suggestion aroused great opposition and was withdrawn the
next month.

SURVEY AND APPROACH

contains remarks—not always illuminating—by the president
or the chairman of the board, relating to the past year's results
and to the future outlook. The distinguishing feature of the
annual report, however, is that it invariably presents the balance-
sheet position.

The information given in the income account varies consider¬
ably in extent. Some reports give no more than the earnings
available for dividends and the amount of dividends paid, e.g .,
United States Leather Company. 1

The Income Account .—In our opinion an annual income
account is not reasonably complete unless it contains the follow¬
ing items: (1) sales, (2) net earnings (before the items following),
(3) depreciation (and depletion), (4) interest charges, (5) non¬
operating income (in detail), (6) income taxes, (7) dividends paid,
(8) surplus adjustments (in detail).

Prior to the passage of the Securities and Exchange Act it
was unfortunately true that loss than half of our industrial
corporations supplied this very moderate quota of information.
(By contrast, data relative to railroads and public utilities have
long been uniformly adequate.) The S.E.C. regulations now
require virtually all this information to be published in the origi¬
nal registration statement (Form 10) and the succeeding annual
reports (Form 10-K). Quite a number of companies have

1 Pocohantas Fuel Company appears to have been the only enterprise
that, although listed on the New York Stock Exchange, published an annual
balance sheet only and provided no income statement of any kind. Its
bonds were removed from listing in October 1934.

The New York Curb dealings include a number of so called “unlisted
issues”—dating from pre-S.E.C. days—which are not subject to require¬
ments of the S.E.C. Among these are companies like American Book,
which does not publish an income account, and New Jersey Zinc, which
publishes an income account but no balance sheet.

Companies whose issues are dealt in “over-the-counter,” and are
thus not subject to S.E.C. regulation, generally publish annual reports
only. They tend to be less detailed than the statements of listed companies,
being especially prone to omit sales and depreciation figures. The great
majority supply both a balance sheet and income account, but exceptions are
fairly numerous. An amusing example is Dun & Bradstreet Corporation.
This purveyor of financial information does not reveal its own earnings to its
stockholders. Other companies omitting income accounts are Bemis
Brothers' Bag, Joseph Dixon Crucible (since 1935), Glenwood Range,
Goodman Manufacturing, Perfection Stove, Regal Shoe, etc.

SECURITY ANALYSIS

requested the S.E.C. to keep their sales figures confidential, on the
ground that publication would be detrimental to the enterprise.
Most of these requests have been cither withdrawn or denied. 1

The standard of reasonable completeness for annual reports,
suggested above, by no means includes all the information which
might be vouchsafed to shareholders. The reports of United
States Steel Corporation may be taken as a model of compre¬
hensiveness. The data there supplied embrace, in addition to
our standard requirements, the following items:

1. Production and sales in units. Rate of capacity operated.

2. Division of sales as between:

Domestic and foreign.

Intercompany and outsiders.

3. Details of operating expenses:

Wages, wage rates, and number of employees.

State and local taxes paid.

Selling and general expense.

Maintenance expenditures, amount and details.

4. Details of capital expenditures during the year.

5. Details of inventories.

6. Details of properties owned.

7. Number of stockholders.

1 A few companies, c.g., Celanese Corporation of America, succeeded in
obtaining a confidential status for their sales figures in certain years prior
to 1938. In some, possibly most, of the cases later requests were denied,
and sales figures were subsequently published.

Our study of the 1938 reports of practically all the industrial companies
listed on the New York Stock Exchange (048 enterprises) disclosed that
only eight had failed to reveal their sales figures by the end of the following
year. The S.E.C. advised that confidential treatment of the sales figure had
been granted to one company (United Fruit) and that no decision had been
reached with respect to the other seven (American Sumatra Tobacco,
Bon Ami, Collins & Aikman, Mathieson Alkali, Mcsta Machine, Shcaffer
Pen, United Engineering and Foundry), as late as December 1939.

Various issues, e.g. } Trico Products Corporation, failed to register and
were dropped from listing, presumably because of their unwillingness to
supply sales figures. The withdrawal of Marlin Rockwell Corporation
from listing in 1938 may be ascribed to the same reason. The stock
exchanges have favored an amendment to the law requiring full disclosure
in the case of over-the-counter issues, to remove what they regard as an
unfair advantage.

Many companies still provide their stockholders in their annual reports
with much less information than they file with the S.E.C. The Standard
Statistics Corporation Records Service , however, regularly publishes the
S.E.C. figures as supplementary data.

SURVEY AND APPROACH

The Balance Sheet .—The form of the balance sheet is better
standardized than the income account and it does not offer
such frequent grounds for criticism. Formerly a widespread
defect of balance sheets was -the failure to separate intangible
from tangible fixed assets, but this is now quite rare in the case of
listed issues. (Among the companies that since 1935 have
disclosed the amount of good-will formerly included in their
property accounts are American Steel Foundries, American
Can, Harbison Walker Refractories, Loose-Wiles Biscuit and
United States Steel. In nearly all these cases the good-will
was written off against surplus.)

Criticism may properly be voiced against the practice of a
great many companies in stating only the net figure for their
property account without showing the deduction for depreciation.
Other shortcomings sometimes met arc the failure to state the
market value of securities owned— e.g., Oppenheim Collins and
Company in 1932; to identify “investments” as marketable or
nonliquid— e.g., Pittsburgh Plate Glass Company; to value the
inventory at lower of cost or market— e.g., Celancse Corporation
of America in 1931; to state the nature of miscellaneous reserves—
e.g., Hazel-Atlas Glass Company; and to state the amount of the
company's own securities held in the treasury— e.g., American
Arch Company. 1

Periodic Reports to Public Agencies.—Railroads and most
public utilities are required to supply information to various
federal and state commissions. Since these data are generally
more detailed than the statements to shareholders, they afford
a useful supplementary source of material. A few practical
illustrations of the value of these reports to commissions may
be of interest.

For many years prior to 1927 Consolidated Gas Company of
New York (now Consolidated Edison Company of New York)
was a “mystery stock” in Wall Street because it supplied very
little information to its stockholders. Great emphasis was laid
by speculators upon the undisclosed value of its interest in its

1 Several of these points were involved in a protracted dispute between
the New York Stock Exchange and Allied Chemical and Dye Corporation,
which was terminated to the satisfaction of the Stock Exchange in 1933.
But the annual reports of the company to shareholders are still inadequate
in that they fail to furnish figures for sales, operating expenses or depreciation.

SECURITY ANALYSIS

numerous subsidiary companies. However, complete operating
and financial data relating to both the company and its sub¬
sidiaries were at all times available in the annual reports of the
Public Service Commission of New York. The same situation
obtained over a long period with respect to the Mackay Com¬
panies, controlling Postal Telegraph and Cable Corporation,
which reported no details to its stockholders but considerable
information to the Interstate Commerce Commission. A
similar contrast exists between the unilluminating reports
of Fifth Avenue Bus Securities Company to its shareholders
and the complete information filed by its operating subsidiary
with the New York Transit Commission.

Finally, we may mention the “ Standard Oil Group” of pipe¬
line companies, which have been extremely chary of information
to their stockholders. But these companies come under the
jurisdiction of the Interstate Commerce Commission, and are
required to file circumstantial annual reports at Washington.
Examination of these reports several years ago would have dis¬
closed striking facts about these companies 7 holdings of cash and
marketable securities.

The voluminous data contained in the Survey of Current
Business , published monthly by the United States Department of
Commerce, have included sales figures for individual chain-store
companies which were not given general publicity— e.g., Waldorf
System, J. R. Thompson, United Cigar Stores, Hartman Corpora¬
tion, etc. Current statistical information regarding particular
companies is often available in trade publications or services.

Examples: Cram's Auto Service gives weekly figures of produc¬
tion for each motor-car company. Willett and Gray publish
several estimates of sugar production by companies during the
crop year. The Oil and Gas Journal often carries data regarding
the production of important fields by companies. The Railway
Age supplies detailed information regarding equipment orders
placed. Dow, Jones and Company estimate weekly the rate of
production of United States Steel.

Listing Applications.—In pre-S.E.C. days these were the most
important nonperiodic sources of information. The reports
required by the New York Stock Exchange, as a condition to
admitting securities to its list, are much more detailed than those
usually submitted to the stockholders. The additional data may

SURVEY AND APPROACH

include sales in dollars, output in units, amount of federal taxes,
details of subsidiaries’ operations, basis and amount of deprecia¬
tion and depletion charges. Valuable information may also be
supplied regarding the properties owned, the terms of contracts,
and the accounting methods followed.

The analyst will find these listing applications exceedingly
helpful. It is unfortunate that they appear at irregular intervals,
and therefore cannot be counted upon as a steady source of
information.

Registration Statements and Prospectuses.—As a result of the
S.E.C. legislation and regulations, the information available
regarding all listed securities and all new securities (whether
listed or not) is much more comprehensive than heretofore.
These data are contained in registration statements filed with
the Commission in Washington and available for inspection or
obtainable in copy upon payment of a fee. The more important
information in the registration statement must be included in
the prospectus supplied by the underwriters to intending pur¬
chasers of new issues. Similar registration statements must be
filed with the S.E.C. under the terms of the Public Utility Act of
1935, which applies to holding companies, some of which might
not come under the other legislation. Although it is true that
the registration statements are undoubtedly too bulky to be
read by the typical investor, and although it is doubtful if he is
even careful to digest the material in the abbreviated prospectus
(which still may cover more than 100 pages), there is no doubt
that this material is proving of the greatest value to the analyst
and through him to the investing public.

Miscellaneous Official Reports.—Information on individual
companies may be unearthed in various kinds of official docu¬
ments. A few examples will give an idea of their miscellaneous
character. The report of the United States Coal Commission in
1923 (finally printed as a Senate Document in 1925) gave financial
and operating data on the anthracite companies which had not
previously been published. Reports of the Federal Trade
Commission have recently supplied a wealth of information
heretofore not available concerning utility operating and
holding companies, and natural-gas and pipe-line companies,
unearthed in an elaborate investigation extending over a period
of about nine years. In 1938 and 1939 the Commission published

SECURITY ANALYSIS

detailed reports on the farm implement and automobile manu¬
facturers. In 1933 a comprehensive study of the pipe-line
companies was published under the direction of the House
Committee on Interstate and Foreign Commerce. Voluminous
studies of the American Telephone and Telegraph System have
emanated from the investigation carried on by the Federal
Communications Commission pursuant to a Congressional
resolution adopted in 1935. 1 Some of the opinions of the Inter¬
state Commerce Commission have contained material of great
value to the analyst. Trustees under mortgages may have infor¬
mation required to be supplied by the terms of the indenture.
These figures may be significant. For example, unpublished
reports with the trustee of Mason City and Fort Dodge Kail road
Company 4s, revealed that the interest on the bonds was not
being earned, that payment thereof was being continued by
Chicago Great Western Railroad Company as a matter of policy
only, and hence that the bonds were in a far more vulnerable
position than was generally suspected.

Statistical and Financial Publications.—Most of the informa¬
tion required by the securities analyst in his daily work may be
found conveniently and adequately presented by the various
statistical services. These include comprehensive manuals pub¬
lished annually with periodic supplements (Poor's, Moody's);
descriptive stock and bond cards, and manuals frequently
revised (Standard & Poor's, Fitch); daily digests of news relating
to individual companies (Standard Corporation Records, Fitch). 2
These services have made great progress during the past 20 years
in the completeness and accuracy with which they present the
facts. Nevertheless they cannot be relied upon to give all the
data available in the various original sources above described.
Some of these sources escape them completely, and in other cases
they may neglect to reproduce items of importance. It follows

1 These reports have been published respectively as Sen. Doc. 92, pts.
1-84D, 70th Congress, 1st Session (1928-1937); House Doc. 702, pts. 1 and
2, 75th Congress, 3d Session (1938); House Doc. 468, 76th Congress, 1st
Session (1939); House Report No. 2192, pts. 1 and 2, 72d Congress, 2d
Session (1933); House Doc* 340, 76th Congress, 1st Session (1939), together
with supplementary reports mentioned on pp. 609-611 thereof; and Pro¬
posed Report, Telephone Investigation Pursuant to Public Resolution
No. 8, 74th Congress (1938).

* During 1941 Poor's Publishing Company and Standard Statistics Com¬
pany merged into Standard & Poor's Corp. The separate Poor's services
have been discontinued.

SURVEY AND APPROACH

therefore that in any thoroughgoing study of an individual com¬
pany, the analyst should consult the original reports and other
documents wherever possible, and not rely upon summaries or
transcriptions.

In the field of financial periodicals, special mention must be
made of The Commercial and Financial Chronicle , a weekly pub¬
lication with numerous statistical supplements. Its treatment
of the financial and industrial field is unusually comprehensive;
and its most noteworthy feature is perhaps its detailed reproduc¬
tion of corporate reports and other documents.

Requests for Direct Information from the Company. —Pub¬
lished information may often be supplemented to an important
extent by private inquiry of or by interview with the manage¬
ment. There is no reason why stockholders should not ask for
information on specific points, and in many cases part at least
of the data asked for will be furnished. It must never be for¬
gotten that a stockholder is an owner of the business and an
employer of its officers. He is entitled not only to ask legitimate
questions but also to have them answered, unless there is some
persuasive reason to the contrary.

Insufficient attention has been paid to this all-important
point. The courts have generally held that a bona fide stock¬
holder has the same right to full information as a partner in a
private business. This right may not be exercised to the detri¬
ment of the corporation, but the burden of proof rests upon the
management to show an improper motive behind the request or
that disclosure of the information would work an injury to the
business.

Compelling a company to supply information involves expen¬
sive legal proceedings and hence few shareholders are in a position
to assert their rights to the limit. Experience shows, however,
that vigorous demands for legitimate information are frequently
acceded to even by the most recalcitrant managements. This is
particularly true when the information asked for is no more than
that which is regularly published by other companies in the same
field.

INFORMATION REGARDING THE INDUSTRY

Statistical data respecting industries as a whole are available
in abundance. The Survey of Current Business , published by the
United States Department of Commerce, gives monthly figures

SECURITY ANALYSIS

on output, consumption, stocks, unfilled orders, etc., for many
different lines. Annual data are contained in the Statisti¬
cal Abstract, the World Almanac and other compendiums.
More detailed figures are available in the Biennial Census of
Manufactures.

Many important summary figures are published at frequent
intervals in the various trade journals. In these publications
will be found also a continuous and detailed picture of the
current and prospective state of the industry. Thus it is
usually possible for the analyst to acquire without undue diffi¬
culty a background of fairly complete knowledge of the history
and problems of the industry with which he is dealing.

In recent years the leading statistical agencies have developed
additional services containing basic surveys of the principal
industrial groups, supplemented frequently by current data
designed to keep the basic surveys up to date. 1

1 For description of these services see Handbook of Commercial and Finan¬
cial Services, Special Libraries Association, New York, 1939.

CHAPTER IV

DISTINCTIONS BETWEEN INVESTMENT AND
SPECULATION

General Connotations of the Term “Investment.” —Invest¬
ment or investing, like “value” in the famous dictum of Justice
Brandeis, is “a word of many meanings.” Of these, three will
concern us here. The first meaning, or set of meanings, relates
to putting or having money in a business. A man “invests”
$1,000 in opening a grocery store; the “return on investment”
in the steel industry (including bonded debt and retained profits)
averaged 2.40% during 1929-1938. 1 The sense here is purely
descriptive; it makes no distinctions and pronounces no judg¬
ments. Note, however, that it accepts rather than rejects the
element of risk—the ordinary business investment is said to be
made “at the risk of the business.”

The second set of uses applies the term in a similar manner to
the field of finance. In this sense all securities are “invest¬
ments.” We have investment dealers or brokers, investment
companies 1 2 or trusts, investment lists. Here, again, no real dis¬
tinction is made between investment and other types of financial
operations such as speculation. It is a convenient omnibus
word, with perhaps an admixture of euphemism— i.e ., a desire to
lend a certain respectability to financial dealings of miscellaneous
character.

Alongside of these two indiscriminate uses of the term “invest¬
ment” has always been a third and more limited connotation—

1 Dollars behind Steel , pamphlet of American Iron and Steel Institute,
New York, 1939.

2 Note that in October 1939 the S.E.C. listed under the title of “Invest¬
ment Company” the offering of stock of “The Adventure Company, Ltd.,”
a new enterprise promoted by “The Discovery Company, Ltd.” The
fact that H par value stock was offered at $10 per share, although not
really significant, has a certain appropriateness.

SECURITY ANALYSIS

that of investment as opposed to speculation. That such a dis¬
tinction is a useful one is generally taken for granted. It is
commonly thought that investment, in this special sense, is good
for everybody and at all times. Speculation, on the other hand,
may be good or bad, depending on the conditions and the person
who speculates. It should be essential, therefore, for anyone
engaging in financial operations to know whether he is investing
or speculating and, if the latter, to make sure that his speculation
is a justifiable one.

The difference between investment and speculation, when the
two are thus opposed, is understood in a general way by nearly
everyone; but when we try to formulate it precisely, we run into
perplexing difficulties. In fact something can be said for the
cynic’s definition that an investment is a successful speculation
and a speculation is an unsuccessful investment. It might be
taken for granted that United States government securities are
an investment medium, while the common stock, say, of Radio
Corporation of America—which between 1931 and 1935 had
neither dividends, earnings nor tangible assets behind it—must
certainly be a speculation. Yet operations of a definitely specu¬
lative nature may be carried on in United States government
bonds ( e.g ., by specialists who buy large blocks in anticipation
of a quick rise); and on the other hand, in 1929 Radio Corpora¬
tion of America common was widely regarded as an investment,
to the extent in fact of being included in the portfolios of leading
“ Investment Trusts.”

It is certainly desirable that some exact and acceptable defini¬
tion of the two terms be arrived at, if only because we ought as
far as possible to know what we are talking about. A more
forceful reason, perhaps, might be the statement that the failure
properly to distinguish between investment and speculation was
in large measure responsible for the market excesses of 1928-
1929 and the calamities that ensued—as well as, we think, for
much continuing confusion in the ideas and policies of would-be
investors. On this account we shall give the question a more
thoroughgoing study than it usually receives. The best pro¬
cedure might be first to examine critically the various meanings
commonly intended in using the two expressions, and then to
endeavor to crystallize therefrom a single sound and definite con¬
ception of investment.

SURVEY AND APPROACH

Distinctions Commonly Drawn between the Two Terms.—The
chief distinctions in common use may be listed in the following
table:

Investment Speculation

1. In bonds. In stocks.

2. Outright purchases. Purchases on margin.

3. For permanent holding. For a “quick turn.”

4. For income. For profit.

5. In safe securities. In risky issues.

The first four distinctions have the advantage of being entirely
definite, and each of them also sets forth a characteristic which
is applicable to the general run of investment or speculation.
They are all open to the objection that in numerous individual
cases the criterion suggested would not properly apply.

1. Bonds vs. Stocks. —Taking up the first distinction, we find
it corresponds to a common idea of investing as opposed to
speculating, and that it also has the weight of at least one author¬
ity on investment who insists that only bonds belong in that
category . 1 The latter contention, however, runs counter to the
well-nigh universal acceptance of high-grade preferred stocks as
media of investment. Furthermore, it is most dangerous to
regard the bond form as possessing inherently the credentials
of an investment, for a poorly secured bond may not only be
thoroughly speculative but the most unattractive form of specu¬
lation as well. It is logically unsound, furthermore, to deny
investment rating to a strongly entrenched common stock merely
because it possesses profit possibilities. Even the popular view
recognizes this fact, since at all times certain especially sound
common stocks have been rated as investment issues and their
purchasers regarded as investors and not as speculators.

2 and 3. Outright vs. Marginal Purchases; Permanent vs.
Temporary Holding. —The second and third distinctions relate
to the customary method and intention , rather than to the innate
character of investment and speculative operations. It should be
obvious that buying a stock outright does not ipso facto make the
transaction an investment. In truth the most speculative issues,
e.g., “penny mining stocks,” must be purchased outright, since
no one will lend money against them. Conversely, when the

1 Lawrence Chamberlain at p. 8 of Investment and Speculation by Chamber-
lain and William W. Hay, New York, 1931.

SECURITY ANALYSIS

American public was urged during the war to buy Liberty Bonds
with borrowed money, such purchases were nonetheless univer¬
sally classed as investments. If strict logic were followed in
financial operations—a very improbable hypothesis!—the com¬
mon practice would be reversed: the safer (investment) issues
would be considered more suitable for marginal purchase, and
the riskier (speculative) commitments would be paid for in full.

Similarly the contrast between permanent and temporary
holding is applicable only in a broad and inexact fashion. An
authority on common stocks has defined an investment as any
purchase made with the intention of holding it for a year or
longer; but this definition is admittedly suggested by its con¬
venience rather than its penetration. 1 The inexactness of this
suggested rule is shown by the circumstance that short-term
investment is a well-established practice. Long-term speculation
is equally well established as a rueful fact (when the purchaser
holds on hoping to make up a loss), and it is also carried on to
some extent as an intentional undertaking.

4 and 6. Income vs. Profit; Safety vs. Risk.—The fourth
and fifth distinctions also belong together, and so joined they
undoubtedly come closer than the others to both a rational and a
popular understanding of the subject. Certainly, through many
years prior to 1928, the typical investor had been interested
above all in safety of principal and continuance of an adequate
income. However, the doctrine that common stocks are the
best long-term investments has resulted in a transfer of empha¬
sis from current income to future income and hence inevitably
to future enhancement of principal value. In its complete sub¬
ordination of the income element to the desire for profit, and
also in the prime reliance it places upon favorable developments
expected in the future, the new-era style of investment—as exem¬
plified in the general policy of the investment trusts—is prac¬
tically indistinguishable from speculation. In fact this so-called
investment can be accurately defined as speculation in the com¬
mon stocks of strongly situated companies.

It would undoubtedly be a wholesome step to go back to the
accepted idea of incofne as the central motive in investment,
leaving the aim toward profit, or capital appreciation, as the

1 Sloan, Laurence H., Everyman and His Common Stocks t pp. 8-9, 279 ff. f
New York, 1931.

SURVEY AND APPROACH

typical characteristic of speculation. But it is doubtful whether
the true inwardness of investment rests even in this distinction.
Examining standard practices of the past, we find some instances
in which current income was not the leading interest of a bona
fide investment operation. This was regularly true, for exam¬
ple, of bank stocks, which until recent years were regarded as
the exclusive province of the wealthy investor. These issues
returned a smaller dividend yield than did high-grade bonds, but
they were purchased on the expectation that the steady growth
in earnings and surplus would result in special distributions and
increased principal value. In other words, it was the earnings
accruing to the stockholder’s credit, rather than those distributed
in dividends, which motivated his purchase. Yet it would not
appear to be sound to call this attitude speculative, for we should
then have to contend that only the bank stocks w r hich paid out
most of their earnings in dividends (and thus gave an adequate
current return) could be regarded as investments, while those
following the conservative policy of building up their surplus
would therefore have to be considered speculative. Such a con¬
clusion is obviously paradoxical; and because of this fact it must
be admitted that an investment in a common stock might con¬
ceivably be founded on its earning power, without reference to
current dividend payments.

Does this bring us back to the new-era theory of investment?
Must we say that the purchase of low-yielding industrial shares
in 1929 had the same right to be called investment as the pur¬
chase of low-yielding bank stocks in prewar days? The answer
to this question should bring us to the end of our quest, but to
deal with it properly we must turn our attention to the fifth and
last distinction in our list—that between safety and risk.

This distinction expresses the broadest concept of all those
underlying the term investment, but its practical utility is handi¬
capped by various shortcomings. If safety is to be judged by
the result, we are virtually begging the question, and come peril¬
ously close to the cynic’s definition of an investment as a suc¬
cessful speculation. 1 Naturally the safety must be posited in
advance, but here again there is room for much that is indefinite
and purely subjective. The race-track gambler, betting on a

1 For a serious suggestion along these lines see Felix I. Shaffner, The
Problem of Investment , pp. 13-19, New York, 1936.

SECURITY ANALYSIS

“sure thing,” is convinced that his commitment is safe. The
1929 “investor” in high-priced common stocks also considered
himself safe in his reliance upon future growth to justify the figure
he paid and more.

Standards of Safety. —The concept of safety can be really
useful only if it is based on something more tangible than the
psychology of the purchaser. The safety must be assured, or at
least strongly indicated, by the application of definite and well-
established standards. It was this point which distinguished
the bank-stock buyer of 1912 from the common-stock investor of
1929. The former purchased at price levels which he considered
conservative in the light of experience; he was satisfied, from his
knowledge of the institution’s resources and earning power, that
he was getting his money’s worth in full. If a strong speculative
market resulted in advancing the price to a level out of line with
these standards of value, he sold his shares and waited for a
reasonable price to return before reacquiring them.

Had the same attitude been taken by the purchaser of common
stocks in 1928-1929, the term investment would not have been
the tragic misnomer that it was. But in proudly applying the
designation “blue chips” to the high-priced issues chiefly favored,
the public unconsciously revealed the gambling motive at the
heart of its supposed investment selections. These differed from
the old-time bank-stock purchases in the one vital respect that
the buyer did not determine that they were worth the price paid
by the application of firmly established standards of value. The
market made up new standards as it went along, by accepting
the current price—however high—as the sole measure of value.
Any idea of safety based on this uncritical approach was clearly
illusory and replete with danger. Carried to its logical extreme,
it meant that no price could possibly be too high for a good stock,
and that such an issue was equally “safe” after it had advanced
to 200 as it had been at 25.

A Proposed Definition of Investment. —This comparison sug¬
gests that it is not enough to identify investment with expected
safety; the expectation must be based on study and standards.
At the same time, the investor need not necessarily be interested
in current income; he may at times legitimately base his purchase
on a return which is accumulating to his credit and realized by
him after a longer or shorter wait. With these observations in

SURVEY AND APPROACH

mind, we suggest the following definition of investment as one in
harmony with both the popular understanding of the term and
the requirements of reasonable precision:

An investment operation is one which , upon thorough analysis ,
promises safety of principal and a satisfactory return . Operations
not meeting these requirements are speculative .

Certain implications of this definition are worthy of further
discussion. We speak of an investment operation rather than an
issue or a purchase, for several reasons. It is unsound to think
always of investment character as inhering in an issue per se .
The price is frequently an essential element, so that a stock (and
even a bond) may have investment merit at one price level but
not at another. Furthermore, an investment might be justified
in a group of issues, which would not be sufficiently safe if made
in any one of them singly. In other words, diversification might
be necessary to reduce the risk involved in the separate issues to
the minimum consonant with the requirements of investment.
(This would be true, in general, of purchases of common stocks
for investment.)

In our view it is also proper to consider as investment oper¬
ations certain types of arbitrage and hedging commitments which
involve the sale of one security against the purchase of another.
In these operations the clement of safety is provided by the com¬
bination of purchase and sale. This is an extension of the ordi¬
nary concept of investment, but one which appears to the writers
to be entirely logical.

The phrases thorough analysis , promises safety and satisfactory
return are all chargeable with indefiniteness, but the important
point is that their meaning is clear enough to prevent serious mis¬
understanding. By thorough analysis we mean, of course, the
study of the facts in the light of established standards of safety
and value. An “analysis” that recommended investment in
General Electric common at a price forty times its highest
recorded earnings merely because of its excellent prospects would
be clearly ruled out, as devoid of all quality of thoroughness.

The safety sought in investment is not absolute or complete;
the word means, rather, protection against loss under all normal
or reasonably likely conditions or variations. A safe bond, for
example, is one which could suffer default only under exceptional
and highly improbable circumstances. Similarly, a safe stock is

SECURITY ANALYSIS

one which holds every prospect of being worth the price paid
except under quite unlikely contingencies. Where study and
experience indicate that an appreciable chance of loss must be
recognized and allowed for, we have a speculative situation.

A satisfactory return is a wider expression than adequate income,
since it allows for capital appreciation or profit as well as current
interest or dividend yield. “Satisfactory” is a subjective term;
it covers any rate or amount of return, however low, which the
investor is willing to accept, provided he acts with reasonable
intelligence.

It may be helpful to elaborate our definition from a somewhat
different angle, which will stress the fact that investment must
always consider the price as well as the quality of the security.
Strictly speaking, there can be no such thing as an “investment
issue” in the absolute sense, i.e. } implying that it remains an
investment regardless of price. In the case of high-grade bonds,
this point may not be important, for it is rare that their prices
are so inflated as to introduce serious risk of loss of principal.
But in the common-stock field this risk may frequently be created
by an undue advance in price—so much so, indeed, that in our
opinion the great majority of common stocks of strong companies
must be considered speculative during most of the time, simply
because their price is too high to warrant safety of principal in
any intelligible sense of the phrase. We must w r arn the reader
that prevailing Wall Street opinion does not agree with us on
this point; and he must make up his own mind which of us is
wrong.

Nevertheless, we shall embody our principle in the following
additional criterion of investment:

An investment operation is one that can be justified on both
qualitative and quantitative grounds.

The extent to which the distinction between investment and
speculation may depend upon the underlying facts, including the
element of price, rather than on any easy generalization, may be
brought home in somewhat extreme fashion by two contrasting
examples based upon General Electric Special (i.e., Preferred)
stock, which occurred in successive months.

Example 1: In December 1934 this issue sold at 12%. It paid
0% on $10 par and was callable on any dividend date at 11. In
spite of the preeminent quality of this issue, as far as safety of

SURVEY AND APPROACH

dividends was concerned, the buyer at 12^£ was speculating to
the extent of more than 10% of his principal. He was virtually
wagering that the issue would not be called for some years to
come. 1 As it happened, the issue was called that very month for
redemption at $11 per share on April 15, 1935.

Example 2: After the issue was called, the price promptly
declined to 11. At that time the issue offered an unusual oppor¬
tunity for profitable short-term investment on margin . Brokers
buying the shares at 11 (without paying commission), say on
January 15, 1935, could have borrowed $10 per share thereon at
not more than 2% per annum. This operation would have
netted a sure return at the rate of 40% per annum on the capital
invested—as shown by the following calculation:

Cost of 1,000 shares at 11 net. $11,000

Redeemed Apr. 15, 1935, at 11 plus dividend. 11,150

Gross profit. 150

Less 3 months' interest at 2% on $10,000. 50

Net profit. 100

Net profit of $100 on $1,000 in 3 months is equivalent to annual
return of 40%.

Needless to say, the safety, and the resultant investment char¬
acter, of this unusual operation derived solely from the fact that
the holder could count absolutely on the redemption of the shares
in April 1935.

The conception of investment advanced above is broader than
most of those in common use. Under it investment may con¬
ceivably—though not usually—be made in stocks, carried on
margin, and purchased with the chief interest in a quick profit.
In these respects it would run counter to the first four distinc¬
tions which we listed at the outset. But to offset this seeming
laxity, we insist on a satisfactory assurance of safety based on
adequate analysis. We are thus led to the conclusion that the
viewpoint of analysis and the viewpoint of investment are largely
identical in their scope.

1 In recent years many United States Government short-term securities
have been purchased at prices yielding less than nothing to maturity in the
expectation that the holders would be given valuable exchange privileges
into new issues. According to our definition all such purchases must be
called speculative to the extent of the premium paid above par and interest
to maturity.

SECURITY ANALYSIS

OTHER ASPECTS OF INVESTMENT AND SPECULATION

Relation of the Future to Investment and Speculation.—It

may be said, with some approximation to the truth, that invest¬
ment is grounded on the past whereas speculation looks primarily
to the future. But this statement is far from complete. Both
investment and speculation must meet the test of the future; they
are subject to its vicissitudes and are judged by its verdict. But
what we have said about the analyst and the future applies
equally well to the concept of investment. For investment,
the future is essentially something to be guarded against rather
than to be profited from. If the future brings improvement, so
much the better; but investment as such cannot be founded in
any important degree upon the expectation of improvement.
Speculation, on the other hand, may always properly—and often
soundly—derive its basis and its justification from prospective
developments that differ from past performance.

Types of “Investment.” —Assuming that the student has
acquired a fairly clear concept of investment in the distinctive
sense that we have just developed, there remains the confusing
effect of the prevalent use of the term in the broader meanings
referred to at the beginning of this chapter. It might be useful
if some descriptive adjective were regularly employed, when care
is needed, to designate the particular meaning intended. Let
us tentatively suggest the following:

1. Business investment —Referring to money put or held in a business.

2. Financial investment

or investment generally—Referring to securities generally.

3. Sheltered investment —Referring to securities regarded as subject to

small risk by reason of their prior claim on
earnings or because they rest upon an adequate
taxing power.

4. Analyst’s investment —Referring to operations that, upon thorough

study, promise safety of principal and an ade¬
quate return.

Evidently these different types of investment are not mutually
exclusive. A good bond, for example, would fall under all four
headings. Unless we -specify otherwise, we shall employ the
word “investment,” and its relatives, in the sense of “analyst’s
investment,” as developed in this chapter.

Types of Speculation.—The distinction between speculation
and gambling assumes significance when the activities of Wall

SURVEY AND APPROACH

Street are subjected to critical scrutiny. It is more or less the
official position of the New York Stock Exchange that “gam¬
bling” represents the creation of risks not previously existing—
e.g.j race-track betting—whereas “ speculation” applies to the tak¬
ing of risks that are implicit in a situation and so must be taken
by someone. A formal distinction between “ intelligent specula¬
tion” and “unintelligent speculation” is no doubt open to strong
theoretical objections, but we do think that it has practical
utility. Thus wc suggest the following:

1. Intelligent speculation —The taking of a risk that appears justified

after careful weighing of the pros and cons.

2. Unintelligent speculation—Risk taking without adequate study of the

situation.

In the field of general business most well-considered enterprises
would belong in the class of intelligent speculations as well as
representing “business investments” in the popular sense.
If the risk of loss is very small—an exceptional occurrence—a
particular business venture may qualify as an analyst's invest¬
ment in our special sense. On the other hand, many ill-con¬
ceived businesses must be called unintelligent speculations.
Similarly, in the field of finance, a great deal of common-stock
buying is done with reasonable care and may be called intelligent
speculation; a great deal, also, is done upon inadequate con¬
sideration and for unsound reasons and thus must be called
unintelligent; in the exceptional case a common stock may be
bought on such attractive terms, qualitative and quantitative,
as to set the inherent risk at a minimum and justify the title of
analyst's investment.

Investment and Speculative Components.—A proposed pur¬
chase that cannot qualify as an “analyst's investment” auto¬
matically falls into the speculative category. But at times it
may be useful to view such a purchase somewhat differently and
to divide the price paid into an investment and a speculative
component. Thus the analyst, considering General Electric
common at its average price of $38 in 1939, might conclude that
up to, say, $25 per share is justified from the strict standpoint
of investment value. The remaining $13 per share will represent
the stock market's average appraisal of the company's excellent
long-term prospects, including therein, perhaps, a rather strong
psychological bias in favor of this outstanding enterprise. On

SECURITY ANALYSIS

the basis of such a study, the analyst would declare that the
price of $38 for General Electric includes an investment
component of some $25 per share and a speculative component
of about $13 per share. If this is sound, it would follow that at a
price of 25 or less, General Electric common would constitute an
“analyst's investment” completely; but above that price the
buyer should recognize that he is paying something for the
company's very real speculative possibilities. 1

Investment Value, Speculative Value and Intrinsic Value.—
The foregoing discussion suggests an amplification of what was
said in Chap. I on the concept of “intrinsic value,” which was
there defined as “value justified by the facts.” It is important
to recognize that such value is by no means limited to “value
for investment”—z.e., to the investment component of total
value—but may properly include a substantial component of
speculative value, provided that such speculative value is
intelligently arrived at. Hence the market price may be said to
exceed intrinsic value only when the market price is clearly the
reflection of unintelligent speculation.

Generally speaking, it is the function of the stock market,
and not of the analyst, to appraise the speculative factors in a
given common-stock picture. To this important extent the
market, not the analyst, determines intrinsic value. The range
of such an appraisal may be very wide, as illustrated by our
former suggestion that the intrinsic value of J. I. Case common in
1933 might conceivably have been as high as 130 or as low as 30.
At any point between these broad limits it would have been
necessary to accept the market's verdict—changeable as it was
from day to day—as representing the best available determina¬
tion of the intrinsic value of this volatile issue.

1 We have intentionally, and at the risk of future regret, used an example
here of a highly controversial character. Nearly everyone in Wall Street
would regard General Electric stock as an “investment issue” irrespective
of its market price and, more specifically, would consider the average price
of $38 as amply justified from the investment standpoint. But we are
convinced that to regard investment quality as something independent of
price is a fundamental and .dangerous error. As to the point at which the
investment value of General Electric ceases and its speculative value begins,
there is naturally room for a fairly wide difference of opinion. Our figure is
only illustrative.

CHAPTER V

CLASSIFICATION OF SECURITIES

Securities are customarily divided into the two main groups
of bonds and stocks, with the latter subdivided into preferred
stocks and common stocks. The first and basic division recog¬
nizes and conforms to the fundamental legal distinction between
the creditors’ position and the partners’ position. The bond¬
holder has a fixed and prior claim for principal and interest; the
stockholder assumes the major risks and shares in the profits of
ownership. It follows that a higher degree of safety should
inhere in bonds as a class, while greater opportunity of specu¬
lative gain—to offset the greater hazard—is to be found in the
field of stocks. It is this contrast, of both legal status and
investment character, as between the two kinds of issues, which
provides the point of departure for the usual textbook treatment
of securities.

Objections to the Conventional Grouping: 1. Preferred
Stock Grouped with Common. —While this approach is hallowed
by tradition, it is open to several serious objections. Of these the
most obvious is that it places preferred stocks with common
stocks, whereas, so far as investment practice is concerned, the
former undoubtedly belong with bonds. The typical or standard
preferred stock is bought for fixed income and safety of principal.
Its owner considers himself not as a partner in the business but
as the holder of a claim ranking ahead of the interest of the
partners, i.e ., the common stockholders. Preferred stockholders
are partners or owners of the business only in a technical, legalistic
sense; but they resemble bondholders in the purpose and expected
results of their investment.

2. Bond Form Identified with Safety. —A weightier though less
patent objection to the radical separation of bonds from stocks
is that it tends to identify the bond form with the idea of safety.
Hence investors are led to believe that the very name “bond”
must carry some especial assurance against loss. This attitude

SECURITY ANALYSIS

is basically unsound, and on frequent occasions is responsible
for serious mistakes and loss. The investor has been spared
even greater penalties for this error by the rather accidental
fact that fraudulent security promoters have rarely taken
advantage of the investment prestige attaching to the bond
form. 1 It is true beyond dispute that bonds as a whole enjoy a
degree of safety distinctly superior to that of the average stock.
But this advantage is not the result of any essential virtue of the
bond form; it follows from the circumstance that the typical
American enterprise is financed with some honesty and intelli¬
gence, and does not assume fixed obligations without a reasonable
expectation of beinc able to meet them. But it is not the obliga¬
tion that creates the safety, nor is it the legal remedies of the
bondholder in the event of default. Safety depends upon and
is measured entirely by the ability of the debtor corporation to meet
its obligations .

The bond of a business without assets or earning power
would be every whit as valueless as the stock of such an enter¬
prise. Bonds representing all the capital placed in a new venture
are no safer than common stock would be, and are considerably
less attractive. For the bondholder could not possibly get more
out of the company by virtue of his fixed claim than he could
realize if he owned the business in full, free and clear. 2 This
simple principle seems too obvious to merit statement; yet
because of the traditional association of the bond form with
superior safety, the investor has often been persuaded that by the
mere act of limiting his return he obtained an assurance against
loss.

3. Failure of Titles to Describe Issues with Accuracy. —The

basic classification of securities into bonds and stocks—or even
into three main classes of bonds, preferred stocks, and common
stocks—is open to the third objection that in many cases these
titles fail to supply an accurate description of the issue. This

1 For an example of fraudulent sales of bonds see Securities Act of 1933:
Release No. 2112, dated Dec. 4, 1939, relating to conviction of various
parties in connection with the sale of American Terminals and Transit
Company bonds and Green River Valley Terminal Company notes.

* See Appendix Note 4, p. 731, for a phase of the liquidation of the United
States Express Company illustrating this point and for the more recent
example of Court-Livingston Corporation.

SURVEY AND APPROACH

is the consequence of the steadily mounting percentage of
securities which do not conform to the standard patterns, but
instead modify or mingle the customary provisions.

Briefly stated, these standard patterns are as follows:

I. The bond pattern comprises:

A. The unqualified right to a fixed interest payment on fixed dates.

B. The unqualified right to repayment of a fixed principal amount
on a fixed date.

C. No further interest in assets cr profits, and no voice in the
management.

II. The preferred-stock pattern comprises:

A. A stated rate of dividend in priority to any payment on the
common. (Hence full preferred dividends are mandatory if the
common receives any dividend; but if nothing is paid on
the common, the preferred dividend is subject to the discretion of
the directors).

B. The right to a stated principal amount in the event of dissolution,
in priority to any payments to the common stock.

C. Either no voting rights, or voting power shared with the common.

III. The common-stock pattern comprises:

A. A pro rata ownership of the company’s assets in excess of its
debts and preferred stock issues.

B. A pro rata interest in all profits in excess of prior deductions.

C. A pro rata vote for the election of directors and for other
purposes.

Bonds and preferred stocks conforming to the above standard
patterns will sometimes be referred to as straight bonds or straight
preferred stocks.

Numerous Deviations from the Standard Patterns. —However,
almost every conceivable departure from the standard pattern
can be found in greater or less profusion in the security markets
of today. Of these the most frequent and important are identi¬
fied by the following designations: income bonds; convertible bonds
and preferred stocks; bonds and preferred stocks with stock-
purchase warrants attached; participating preferred stocks;
common stocks with preferential features; nonvoting common
stock. Of recent origin is the device of making bond interest
or preferred dividends payable either in cash or in common
stock at the holder's option. The callable feature now found in
most bonds may also be termed a lesser departure from the
standard provision of fixed maturity of principal.

SECURITY ANALYSIS

Of less frequent and perhaps unique deviations from the
standard patterns, the variety is almost endless. 1 We shall
mention here only the glaring instance of Great Northern Railway
Preferred Stock which for many years has been in all respects a
plain common issue; and also the resort by Associated Gas and
Electric Company to the insidious and highly objectionable
device of bonds convertible into preferred stock at the option of
the company —which are, therefore, not true bonds at all.

More striking still is the emergence of completely distinctive
types of securities so unrelated to the standard bond or stock
pattern as to require an entirely different set of names. Of these,
the most significant is the option warrant—a device which during
the years prior to 1929 developed into a financial instrument of
major importance and tremendous mischief-making powers.
The option warrants issued by a single company—American and
Foreign Power Company—attained in 1929 an aggregate market
value of more than a billion dollars , a figure exceeding our national
debt in 1914. A number of other newfangled security forms,
bearing titles such as allotment certificates and dividend partici¬
pations, could be mentioned. 2

The peculiarities and complexities to be found in the present-
day security list are added arguments against the traditional
practice of pigeonholing and generalizing about securities in
accordance with their titles . While this procedure has the merit
of convenience and a certain rough validity, we think it should
be replaced by a more flexible and accurate basis of classification.
In our opinion, the criterion most useful for purposes of study
would be the normal behavior of the issue after purchase—in
other words its risk-and-profit characteristics as the buyer or
owner would reasonably view them.

1 The reader is referred to Appendix Note 3 of the first edition of this
work for a comprehensive list of these deviations, with examples of each.
To save space that material is omitted from this edition.

* In June 1939 the S.E.C. set a salutary precedent by refusing to authorize
the issuance of “Capital Income Debentures” in the reorganization of the
Griess-Pfleger Tanning Company, on the ground that the devising of new
types of hybrid issues had gone far enough. See S.E.C. Corporate
Reorganization Release No. 13, dated June 16, 1939. Unfortunately,
the court failed to see the matter in the same light and approved the issuance
of the new security.

SURVEY AND APPROACH

New Classification Suggested. —With this standpoint in mind y
we suggest that securities be classified under the following three
headings:

Class • Representative Issue

I. Securities of the fixed-value type. A high-grade bond or preferred

stock.

II/Senior securities of the variable-
value type.

A. Well-protected issues with A high-grade convertible bond,
profit possibilities.

B. Inadequately protected A luv>cr-grade bond or preferred

issues. stock.

III. Common-stock type. A common stock.

An approximation to the above grouping could be reached by
the use of more familiar terms, as follows:

I. Investment bonds and preferred stocks.

II. Speculative bonds and preferred stocks.

A. Convertibles, etc.

B. Low-grade senior issues.

III. Common stocks.

The somewhat novel designations that we employ are needed
to make our classification more comprehensive. This necessity
will be clearer, perhaps, from the following description and dis¬
cussion of each group.

Leading Characteristics of the Three Types .—The first class
includes issues, of whatever title, in which prospective change
of value may fairly be said to hold minor importance. 1 The
owner’s dominant interest lies in the safety of his principal and
his sole purpose in making the commitment is to obtain a steady
income. In the second class, prospective changes in the value
of the principal assume real significance. In Type A } the inves¬
tor hopes to obtain the safety of a straight investment, with an
added possibility of profit by reason of a conversion right or some

1 The actual fluctuations in the price of long-term investment bonds
since 1914 have been so wide (see chart on p. 7) as to suggest that these
price changes must surely be of more than minor importance. It is true,
nonetheless, that the investor habitually acts as if they were of minor
importance to him, so that, subjectively at least, our criterion and title are
justified. To the objection that this is conniving at self-delusion by the
investor, we may answer that on the whole he is likely to fare better by
overlooking the price variations of high-grade bonds than by trying to take
advantage of them and thus transforming himself into a trader.

SECURITY ANALYSIS

similar privilege. In Type B y a definite risk of loss is recognized,
which is presumably offset by a corresponding chance of profit.
Securities included in Group III? will differ from the common-
stock type (Group III) in two respects: (1) They enjoy an effec¬
tive priority over some junior issue, thus giving them a certain
degree of protection. (2) Their profit possibilities, however
substantial, have a fairly definite limit, in contrast with the
unlimited percentage of possible gain theoretically or optimisti¬
cally associated with a fortunate common-stock commitment.

Issues of the fixed-value type include all straight bonds and
preferred stocks of high quality selling at a normal price. Besides
these, there belong in this class:

1. Sound convertible issues where the conversion level is too remote to
enter as a factor in the purchase. (Similarly for participating or warrant¬
bearing senior issues.)

2. Guaranteed common stocks of investment grade.

3. “ Class A ” or prior-common stocks occupying the status of a high-
grade, straight preferred stock.

On the other hand, a bond of investment grade which happens
to sell at any unduly low price would belong in the second group,
since the purchaser might have reason to expect and be interested
in an appreciation of its market value.

Exactly at what point the question of price fluctuation becomes
material rather than minor is naturally impossible to prescribe.
The price level itself is not the sole determining factor. A long¬
term 3% bond selling at 60 may have belonged in the fixed-
value class (e.g., Northern Pacific Railway 3s, due 2047 between
1922 and 1930), whereas a one : year maturity of any coupon rate
selling at 80 would not —because in a comparatively short time it
must either be paid off at a 20-point advance or else default and
probably suffer a severe decline in market value. We must be
prepared, therefore, to find marginal cases where the classification
(as between Group I and Group II) will depend on the personal
viewpoint of the analyst or investor.

Any issue which displays the main characteristics of a common
stock belongs in Group III, whether it is entitled “common
stock,” “preferred stock” or even “bond.” The case, already
cited, of American Telephone and Telegraph Company Con¬
vertible 4J£s, when selling about 200, provides an apposite
example. The buyer or holder of the bond at so high a level

SURVEY AND APPROACH

was to all practical purposes making a commitment in the com¬
mon stock, for the bond and stock would not only advance
together but also decline together over an exceedingly wide
price range. Still more definite illustration of this point was
supplied by the Krcuger and Toll Participating Debentures at
the time of their sale to the public. The offering price was so
far above the amount of their prior claim that their title had no
significance at all, and could only have been misleading. These
“bonds” were definitely of the common-stock type. 1

The opposite situation is met when issues, senior in name, sell
at such low prices that the junior securities can obviously have no
real equity, i.e. y ownership interest, in the company. In such
cases, the low-priced bond or preferred stock stands virtually
in the position of a common stock and should be regarded as such
for purposes of analysis. A preferred stock selling at 10 cents on
the dollar, for example, should be viewed not as a preferred stock
at all, but as a common stock. On the one hand it lacks the
prime requisite of a senior security, viz., that it should be followed
by a junior investment of substantial value. On the other hand,
it carries all the profit features of a common stock, since the
amount of possible gain from the current level is for all practical
purposes unlimited.

The dividing line between Groups II and III is as indefinite
as that between Groups I and II. Borderline cases can be
handled without undue difficulty however, by considering them
from the standpoint of either category or of both. For example,
should a 7% preferred stock selling at 30 be considered a low-
priced senior issue or as the equivalent of a common stock? The
answer to this question will depend partly on the exhibit of the
company and partly on the attitude of the prospective buyer.
If real value may conceivably exist in excess of the par amount
of the preferred stock, the issue may be granted some of the
favored status of a senior security. On the other hand, whether
or not the buyer should consider it in the same light as a common
stock may also depend on whether ho would be amply satisfied
with a possible 250% appreciation, or is looking for even greater
speculative gain. 2

1 See Appendix Note 5, p. 732, for the terms of this issue.

•There were many preferred stocks of this kind in 1932— e.g. t Interstate
Department Stores Preferred which sold at an average price of about

SECURITY ANALYSIS

From the foregoing discussion the real character and purpose
of our classification should now be more evident. Its basis is
not the title of the issue, but the practical significance of its
specific terms and status to the owner. Nor is the primary
emphasis placed upon what the owner is legally entitled to
demand, but upon what he is likely to get, or is justified in
expecting, under conditions which appear to be probable at the
time of purchase or analysis.

30 in 1932 and 1933 and then advanced to 107 in 1936 and 1937. A similar
remark applies to low-priced bonds, such as those mentioned in the table on
p. 337.

PART n

FIXED-VALUE INVESTMENTS

CHAPTER VI

THE SELECTION OF FIXED-VALUE INVESTMENTS

Having suggested a classification of securities by character
rather than by title, we now take up in order the principles and
methods of selection applicable to each group. We have already
stated that the fixed-value group includes:

1. High-grade straight bonds and preferred stocks.

2. High-grade privileged issues, where the value of the privilege is too
remote to count as a factor in selection.

3. Common stocks which through guaranty or preferred status occupy
the position of a high-grade senior issue.

Basic Attitude toward High-grade Preferred Stocks.—By

placing gilt-edged preferred stocks and high-grade bonds in a
single group, we indicate that the same investment attitude and
the same general method of analysis are applicable to both types.
The very definite inferiority of the preferred stockholders’ legal
claim is here left out of account, for the logical reason that the
soundness of the best investments must rest not upon legal rights
or remedies but upon ample financial capacity of the enterprise.
Confirmation of this viewpoint is found in the investor’s attitude
toward such an issue as National Biscuit Company Preferred,
which for nearly 40 years has been considered as possessing the
same essential investment character as a good bond. 1

Preferred Stocks Not Generally Equivalent to Bonds in Invest¬
ment Merit. —But it should be pointed out immediately that
issues with the history and standing of National Biscuit Pre¬
ferred constitute a very small percentage of ail preferred stocks.
Hence, we are by no means asserting the investment equivalence
of bonds and preferred stocks in general. On the contrary, we

1 See Appendix Note 6, p. 733, for supporting data.

SECURITY ANALYSIS

shall in a later chapter be at some pains to show that the average
preferred issue deserves a lower rank than the average bond,
and furthermore that preferred stocks have been much too
readily accepted by the investing public. The majority of these
issues have not been sufficiently well protected to assure continu¬
ance of dividends beyond any reasonable doubt . They belong
properly, therefore, in the class of variable or speculative senior
issues (Group II), and in this field the contractual differences
between bonds and preferred shares are likely to assume great
importance. A sharp distinction must, therefore, be made
between the typical and the exceptional preferred stock. It is
only the latter which deserves to rank as a fixed-value investment
and to be viewed in the same light as a good bond. To avoid
awkwardness of expression in this discussion we shall frequently
use the terms “investment bonds” or merely “bonds” to repre¬
sent all securities belonging to the fixed-value class.

Is Bond Investment Logical?—In the 1934 edition of this
work we considered with some seriousness the question whether
or not the extreme financial and industrial fluctuations of the
preceding years had not impaired the fundamental logic of bond
investment. Was it worth while for the investor to limit his
income return and to forego all prospect of speculative gain, if
despite these sacrifices he must still subject himself to serious
risk of loss? We suggested in reply that the phenomena of
1927-1933 were so completely abnormal as to afford no fair basis
for investment theory and practice. Subsequent experience
seems to have borne us out, but there are still enough uncer¬
tainties facing the bond buyer to banish, perhaps for a long
time, his old sense of complete security. The combination of a
record high level for bonds (in 1940) with a history of two
catastrophic price collapses in the preceding twenty years and a
major war in progress is not one to justify airy confidence in the
future.

Bond Form Inherently Unattractive: Quantitative Assurance
of Safety Essentials. —This situation clearly calls for a more
critical and exacting attitude towards bond selection than was
formerly considered necessary by investors, issuing houses,
or authors of textbooks on investment. Allusion has already
been made to the dangers inherent in the acceptance of the
bond form as an assurance of safety, or even of smaller risk than

FIXED-VALUE INVESTMENTS

is found in stocks. Instead of associating bonds primarily
with the presumption of safety —as has long been the practice—
it would be sounder to start with what is not presumption but
fact, viz., that a (straight) bond is an investment with limited
return . In exchange for limiting his participation in future
profits, the bondholder obtains a prior claim and a definite
promise of payment, while the preferred stockholder obtains only
the priority, without the promise. But neither priority nor
promise is itself an assurance of payment. This assurance rests
in the ability of the enterprise to fulfill its promise, and must be
looked for in its financial position, record, and prospects. The
essence of proper bond selection consists, therefore, in obtaining
specific and convincing factors of safety in compensation for the
surrender of participation in profits.

Major Emphasis on Avoidance of Loss. —Our primary con¬
ception of the bond as a commitment with limited return leads
us to another important viewpoint toward bond investment.
Since the chief emphasis must be placed on avoidance of loss,
bond selection is primarily a negative art. It is a process of
exclusion and rejection, rather than of search and acceptance.
In this respect the contrast with common-stock selection is
fundamental in character. The prospective buyer of a given
common stock is influenced more or less equally by the desire
to avoid loss and the desire to make a profit. The penalty for
mistakenly rejecting the issue may conceivably be as great as
that for mistakenly accepting it. But an investor may reject
any number of good bonds with virtually no penalty at all,
provided he does not eventually accept an unsound issue.
Hence, broadly speaking, there is no such thing as being unduly
captious or exacting in the purchase of fixed-value investments.
The observation that Walter Bagehot addressed to commercial
bankers is equally applicable to the selection of investment
bonds. “If there is a difficulty or a doubt the security should
be declined.” 1

Four Principles for the Selection of Issues of the Fixed-value

Type. —Having established this general approach to our problem,
we may now state four additional principles of more specific
character which are applicable to the selection of individual
issues:

1 Lombard Street , p. 245, New York, 1892.

SECURITY ANALYSIS

I. Safety is measured not by specific lien or other contractual rights , but
by the ability of the issuer to meet all of its obligations . 1

II. This ability should be measured under conditions of depression rather
than prosperity .

III. Deficient safety cannot be compensated for by an abnormally high coupon
rate .

IV. The selection of all bonds for investment should be subject to rules of
exclusion and to specific quantitative tests corresponding to those prescribed by
statute to govern investments of savings banks .

A technique of bond selection based on the above principles
will differ in significant respects from the traditional attitude
and methods. In departing from old concepts, however, this
treatment represents not an innovation but the recognition and
advocacy of viewpoints which have been steadily gaining ground
among intelligent and experienced investors. The ensuing
discussion is designed to make clear both the nature and the
justification of the newer ideas. 2

1. SAFETY NOT MEASURED BY LIEN BUT BY ABILITY TO PAY

The basic difference confronts us at the very beginning. In
the past the primary emphasis was laid upon the specific security,
i.e., the character and supposed value of the property on which
the bonds hold a lien. From our standpoint this consideration
is quite secondary; the dominant clement must be the strength
and soundness of the obligor enterprise. There is here a clear-
cut distinction between two points of view. On the one hand the
bond is regarded as a claim against 'property; on the other hand,
as a claim against a business.

The older view was logical enough in its origin and purpose.
It desired to make the bondholder independent of the risks of
the business by giving him ample security on which to levy in
the event that the enterprise proved a failure. If the business
became unable to pay his claim, he could take over the mortgaged
property and pay himself out of that. This arrangement would
be excellent if it worked, but in practice it rarely proves to be
feasible. For this there are three reasons:

1 This is a general rule applicable to the majority of bonds of the fixed-
value type, but it is subject to a number of exceptions which are discussed
later.

* These ideas are neither so new nor so uncommon in 1940 as they were in
1934, but we doubt whether they may be considered standard as yet.

FIXED-VALUE INVESTMENTS

1. The shrinkage of property values when the business fails.

2. The difficulty of asserting the bondholders’ supposed legal rights.

8. The delays and other disadvantages incident to a receivership.

Lien Is No Guarantee against Shrinkage of Values.—The
conception of a mortgage lien as a guaranty of protection inde¬
pendent of the success of the business itself is in most cases a
complete fallacy. In the typical situation, the value of the
pledged property is vitally dependent on the earning power of
the enterprise. The bondholder usually has a lien on a railroad
line, or on factory buildings and equipment, or on power plants
and other utility properties, or perhaps on a bridge or hotel
structure. These properties are rarely adaptable to uses other
than those for which they were constructed. Hence if the
enterprise proves a failure its fixed assets ordinarily suffer an
appalling shrinkage in realizable value. For this reason the
established practice of stating the original cost or appraised
value of the pledged property as an inducement to purchase
bonds is entirely misleading. The value of pledged assets
assumes practical importance only in the event of default, and
in any such event the book figures are almost invariably found
to be unreliable and irrelevant. This may be illustrated by
Seaboard-All Florida Railway First Mortgage 6s, selling in
1931 at 1 cent on the dollar shortly after completion of the road. 1

Impracticable to Enforce Basic Legal Rights of Lien Holder.—
In cases where the mortgaged property is actually worth as
much as the debt, the bondholder is rarely allowed to take
possession and realize upon it. It must be recognized that the
procedure following default on a corporation bond has come to
differ materially from that customary in the case of a mortgage
on privately owned property. The basic legal rights of the lien
holder are supposedly the same in both situations. But in
practice we find a very definite disinclination on the part of the
courts to permit corporate bondholders to take over properties
by foreclosing on their liens, if there is any possibility that these
assets may have a fair value in excess of their claim. 1 Apparently
it is considered unfair to wipe out stockholders or junior bond-

1 See Appendix Note 7, p. 733, for supporting data.

•The failure to foreclose on Interborough Rapid Transit Secured 7s
for seven years after default of principal (discussed on p. 730) well illus¬
trates this point.

SECURITY ANALYSIS

holders who have a potential interest in the property but are not
in a position to protect it. As a result of this practice, bond¬
holders rarely, if ever, come into actual possession of the pledged
property unless its value at the time is substantially less than
their claim. In most cases they are required to take new securi¬
ties in a reorganized company. Sometimes the default in interest
is cured and the issue reinstated. 1 On exceedingly rare occasions
a defaulted issue may be paid off in full, but only after a long
and vexing delay. 2

Delays Are Wearisome. —This delay constitutes the third
objection to relying upon the mortgaged property as protection
for a bond investment. The more valuable the pledged assets
in relation to the amount of the lien, the more difficult it is to
take them over under foreclosure, and the longer the time
required to work out an “equitable” division of interest among
the various bond and stock issues. Let us consider the most
favorable kind of situation for a bondholder in the event of receiv¬
ership. He would hold a comparatively small first mortgage fol¬
lowed by a substantial junior lien, the requirements of which have
made the company insolvent. It may well be that the strength of
the first-mortgage bondholder’s position is such that at no time is
there any real chance of eventual loss to him. Yet the financial
difficulties of the company usually have a depressing effect on
the market price of all its securities, even those presumably
unimpaired in real value. As the receivership drags on, the
market decline becomes accentuated, since investors are constitu¬
tionally averse to buying into a troubled situation. Eventually
the first-mortgage bonds may come through the reorganization
undisturbed, but during a wearisome and protracted period
the owners have faced a severe impairment in the quoted value
of their holdings and at least some degree of doubt and worry
as to the outcome. Typical examples of such an experience can
be found in the case of Missouri, Kansas and Texas Railway
Company First 4s and Brooklyn Union Elevated Railroad First
5s. s The subject of receivership and reorganization practice,

1 See Appendix Note 8, p. 734, for supporting data.

* See Appendix Note 9, p. 734, for supporting data.

1 See Appendix Note 10, p. 734, for supporting data. On the subject of
delays in enforcing bondholders’ claims, it should be pointed out that, with
up to one-third of the country’s railroad mileage in bankruptcy, not a

FIXED-VALVE INVESTMENTS 83

particularly as they affect the bondholder, will receive more
detailed consideration in a later chapter.

Basic Principle Is to Avoid Trouble. —The foregoing discussion
should support our emphatic stand that the primary aim of
the bond buyer must be to avoid trouble and not to protect
himself in the event of trouble. Even in the cases where the
specific lien proves of real advantage, this benefit is realized
under conditions which contravene the very meaning of fixed-
value investment. In view of the severe decline in market price
almost invariably associated with receivership, the mere fact
that the investor must have recourse to his indenture indicates
that his investment has been unwise or unfortunate. The
protection that the mortgaged property offers him can constitute
at best a mitigation of his mistake.

Corollaries from This First Principle. 1. Absence of Lien of
Minor Consequence .—From Principle I there follow a number
of corollaries with important practical applications. Since spe¬
cific lien is of subordinate importance in the choice of high-grade
bonds, the absence of lien is also of minor consequence. The
debenture, 1 i.e., unsecured, obligations of a strong corporation,
amply capable of meeting its interest charges, may qualify for

single road emerged from trusteeship in the six years following passage of the
Sec. 77 amendment to the Bankruptcy Act in 1933—a step designed to
accelerate reorganization.

1 The term “debenture” in American financial practice has the accepted
meaning of “unsecured bond or note.” For no good reason, the name is
somfetimes given to other kinds of securities without apparently signifying
anything in particular. There have been a number of “secured debentures,”
e.g.y Chicago Herald and Examiner Secured Debenture CJ^s, due 1950, and
Lone Star Gas Debenture 3Ks, due 1953. Also, a number of preferred
issues are called debenture preferred stock or merely debenture stock, e.g.y
Du Pont Debenture Stock (called in 1939); General Cigar Company Deben¬
ture Preferred (called in 1927).

Sometimes debenture issues, properly so entitled because originally
unsecured, later acquire specific security through the operation of a pro¬
tective covenant, e.g. } New York, New Haven and Hartford Railroad Com¬
pany Debentures, discussed in Chap. XIX. Another example was the
Debenture 6J£s of Fox New England Theaters, Inc., reorganized in 1933.
These debentures acquired as security a block of first-mortgage bonds of the
same company, which were surrendered by the vendor of the theaters
because it failed to meet a guarantee of future earnings.

Observe that there is no clear-cut distinction between a “bond” and a
“note” other than the fact that the latter generally means a relatively

SECURITY ANALYSIS

acceptance almost as readily as a bond secured by mortgage.
Furthermore the debentures of a strong enterprise are undoubt¬
edly sounder investments than the mortgage issues of a weak
company. No first-lien bond, for example, enjoys a better
investment rating than Standard Oil of New Jersey Deben¬
ture 3s, due 1961. An examination of the bond list will show
that the debenture issues of companies having no secured debt
ahead of them will rank in investment character at least on a
par with the average mortgage bond, because an enterprise must
enjoy a high credit rating to obtain funds on its unsecured long¬
term bond. 1

2. The Theory of Buying the Highest Yielding Obligation of a
Sound Company .—It follows also that if any obligation of an
enterprise deserves to qualify as a fixed-value investment, then
all its obligations must do so. Stated conversely, if a company's
junior bonds are not safe, its first-mortgage bonds are not a
desirable fixed-value investment. For if the second mortgage
is unsafe the company itself is weak, and generally speaking there
can be no high-grade obligations of a weak enterprise. The
theoretically correct procedure for bond investment, therefore,
is first to select a company meeting every test of strength and
soundness, and then to purchase its highest yielding obligation,
which would usually mean its junior rather than its first-lien
bonds. Assuming no error were ever made in our choice of
enterprises, this procedure would work out perfectly well in
practice. The greater the chance of mistake, however, the more
reason to sacrifice yield in order to reduce the potential loss in
capital value. But we must recognize that in favoring the lower
yielding first-mortgage issue, the bond buyer is in fact expressing
a lack of confidence in his own judgment as to the soundness of
the business—which, if carried far enough, would call into ques¬
tion the advisability of his making an investment in any of the
bonds of the particular enterprise.

short-term obligation, t.e., one maturing not more than, say, ten years after
issuance.

1 This point is strikingly substantiated by the industrial bond financing
between 1935 and 1939. During these years, when only high-grade issues
could be sold, by far the greater part of the total was represented by
debentures .

FIXED-VALUE INVESTMENTS

Example: As an example of this point, let us consider the
Cudahy Packing Company First Mortgage 5s, due 1946, and the
Debenture 5J^s of the same company, due 1937. In June 1932
the First 5s sold at 95 to yield about 534 %> whereas the junior
534s sold at 59 to yield over 20% to maturity. The purchase of
the 5% bonds at close to par could only be justified by a confi¬
dent belief that the company would remain solvent and reason¬
ably prosperous, for otherwise the bonds would undoubtedly
suffer a severe drop in market price. But if the investor has con¬
fidence in the future of Cudahy, why should he not buy the
debenture issue and obtain an enormously greater return on his
money? The only answer can be that the investor wants the
superior protection of the first mortgage in the event his judg¬
ment proves incorrect and the company falls into difficulties. In
that case he would probably lose less as the owner of the first-
mortgage bonds than through holding the junior issue. Even on
this score it should be pointed out that if by any chance Cudahy
Packing Company were to suffer the reverses that befell Fisk
Rubber Company, the loss in market value of the first-mortgage
bonds would be fully as great as those suffered by the deben¬
tures; for in April 1932 Fisk Rubber Company First 8s were
selling as low as 17 against a price of 12 for the unsecured 534%
Notes. It is clear, at any rate, that the investor who favors the
Cudahy first-lien 5s is paying a premium of about 15% per
annum (the difference in yield) for only a partial insurance
against loss. On this basis he is undoubtedly giving up too
much for what he gets in return. The conclusion appears ines¬
capable either that he should make no investment in Cudahy
bonds or that he should buy the junior issue at its enormously
higher yield. 1 This rule may be laid down as applying to the
general case where a first-mortgage bond sells at a fixed-value
price ( e.g ., close to par) and junior issues of the same company can
be bought to yield a much higher return. 2

3. Senior Liens Are to Be Favored , Unless Junior Obligations
Offer a Substantial Advantage .—Obviously a junior lien should be

1 Both of the Cudahy issues were retired at 102H in 1935.

1 Exceptions to this rule may be justified in rare cases where the senior
security has an unusually preferred status— e.g., a very strongly entrenched
underlying railroad bond. But see infra pp. 88-90.

SECURITY ANALYSIS

preferred only if the advantage in income return is substantial.
Where the first-mortgage bond yields only slightly less, it is
undoubtedly wise to pay the small insurance premium for pro¬
tection against unexpected trouble.

Example: This point is illustrated by the relative market
prices of Atchison Topeka and Santa Fe Railway Company Gen¬
eral (first) 4s and Adjustment (second mortgage) 4s, both of
which mature in 1995.

Price of Atchison General 4s and Adjustment 4s at Various Dates

Date

Price of
General 4s

Price of
Adjustment
4s

Spread

Jan. 2, 1913.

9734

954

Jan. 5, 1917 .

95 54

8654

8 %

May 21, 1920 .

70 54

854

Aug. 4, 1922 .

9354

8454

Dec. 4, 1925.

8954

8554

Jan. 3, 1930 .

9334

Jan. 7, 1931.

9834

154

June 2, 1932.

6654

1454

June 19, 1933.

Jan. 9, 1934.

9454

1154

Mar. 6, 1936.

11454

11354

154

Apr. 26, 1937.

10334

10654

354

Apr. 14, 1938.

9954

7554

Dec. 29, 1939.

10554

8554

2054

Prior to 1924 the Atchison General 4s sold usually at about
7 to 10 points above the Adjustment 4s and yielded about Yl%
less. Since both issues were considered safe without question,
it would have been more logical to purchase the junior issue at
its 10% lower cost. After 1923 this point of view asserted
itself, and the price difference steadily narrowed. During 1930
and part of 1931 the junior issue sold on numerous occasions at
practically the same price as the General 4s. This relationship
was even more illogical than the unduly wide spread in 1922-
1923, since the advantage of the Adjustment 4s in price and yield
was too negligible to warrant accepting a junior position, even
assuming unquestioned safety for both liens.

Within a very short time this rather obvious truth was brought
home strikingly by the widening of the spread to over 14 points

FIXED-VALUE INVESTMENTS

during the demoralized bond-market conditions of June 1932.
As the record appeared in 1934, it could be inferred that a reason¬
able differential between the two issues would be about 5 points
and that either a substantial widening or a virtual disappearance
of the spread would present an opportunity for a desirable
exchange of one issue for another. Two such opportunities did
in fact appear in 1934 and 1936, as shown in our table.

But this example is of further utility in illustrating the all-
pervasive factor of change and the necessity of taking it into
account in bond analysis. By 1937 the failure of Atchison’s
earnings to recover within striking distance of its former normal,
and the actual inadequacy of the margin above interest require¬
ments as judged by conservative standards, should have warned
the investor that the “ adjustment” (z.e., contingent) element in
the junior issue could not safely be ignored. Thus a price rela¬
tionship that was logical at a time when safety of interest was
never in question could not be relied upon under the new condi¬
tions. In 1938 the poor earnings actually compelled the road to
defer the May 1 interest payment on the adjustment bonds, as a
result of which their price fell to 75% and the spread widened to
24 points. Although the interest was later paid in full and the
price recovered to 96 in 1939, it would seem quite unwise for the
investor to apply pre-1932 standards to this bond issue.

A junior lien of Company X may be selected in preference to
a first-mortgage bond of Company Y , on one of tw r o bases:

1. The protection for the total debt of Company X is adequate and the
yield of the junior lien is substantially higher than that of the Company Y
issue; or

2. If there is no substantial advantage in yield, then the indicated protec¬
tion for the total debt of Company X must be considerably better than that
of Company Y .

Example of 2:

Issue

Price

Fixed charges

in 1930

earned, 1929*

Pacific Power and Light Co. First 5s, due 1955..
American Gas and Electric Co. Debenture 5s,

101

1.53 times

due 2028.

101

2.52 times

* Average results approximately the same.

SECURITY ANALYSIS

The appreciably higher coverage of total charges by American
Gas and Electric would have justified preferring its junior bonds
to the first-mortgage issue of Pacific Power and Light, when both
were selling at about the same price. 1

Special Status of “Underlying Bonds.”—In the railroad field an
especial investment character is generally supposed to attach
to what are known as “underlying bonds.” These represent
issues of relatively small size secured by a lien on especially
important parts of the obligor system, and often followed by a
series of “blanket mortgages.” The underlying bond usually
enjoys a first lien, but it may be a second- or even a third-
mortgage issue, provided the senior issues are also of compara¬
tively small magnitude.

Example: New York and Erie Railroad Third Mortgage
Extended 4}^s, due 1938, are junior to two small prior liens
covering an important part of the Erie Railroad’s main line.
They are followed by four successive blanket mortgages on the
system, and they have regularly enjoyed the favored status of
an underlying bond.

Bonds of this description have been thought to be entirely safe,
regardless of what happens to the system as a whole. They have
almost always come through reorganization unscathed; and even
during a receivership interest payments are usually continued
as a matter of course, largely because the sum involved is pro¬
portionately so small. They are not exempt, however, from
fairly sharp declines in market value if insolvency overtakes the
system.

Examples: In the case of New York and Erie Third 4J^s
(which had been voluntarily extended on maturity in 1923 and
again in 1933), principal and interest were defaulted in March
1938, following the bankruptcy of the Erie two months earlier.
The bid price declined to as low as 61. However, the various
reorganization plans filed to the end of 1939 all provided for
the payment of principal and interest in full on this issue.

Chicago and Eastern Illinois Consolidated 6s, due 1934, were
finally paid off in full in 1940, with further interest at 4%—but
not until their price had fallen as low as 32 in 1933.

1 In 1937 the low price of Pacific Power and Light 5s was 51, against a
low of 104 for the American Gas and Electric Debentures.

FIXED-VALUE INVESTMENTS

Pacific Railway of Missouri First 4s and Second 6s and
Missouri Pacific Railway Third 4s, all extended from their
original maturities to 1938, are underlying bonds of the Mis¬
souri Pacific system. They continued to receive interest and
were left undisturbed in the receivership of 1915. Following the
second bankruptcy in 1933, they continued to receive interest
until their maturity date. At that time payment of principal
was defaulted, but interest payments were continued through
1939. The various reorganization plans virtually provided for
these bonds in full, by offering them prior-lien, fixed-interest
obligations of the new company. But since 1931, the price
of these three issues has been as low as 65, 60, and 53, respectively.

Other bonds, however, once regarded as underlying issues, have
not fared so well following insolvency.

Example: Milwaukee, Sparta and Northwestern First 4s, due
1947, ranked as an underlying bond of the Chicago and North
Western Railway, and for many years their price was not far
below that of the premier Union Pacific First 4s, due the same
year. Yet the receivership of the Chicago and North Western
was followed by default of interest on this issue in 1935 and
collapse of its price to the abysmal low of 8^ as late as 1939.

From the foregoing it would appear that in some cases under¬
lying bonds may be viewed as exceptions to our rule that a bond
is not sound unless the company is sound. For the most part
such bonds are owned by institutions or large investors. (The
same observations may apply to certain first-mortgage bonds
of operating subsidiaries of public-utility holding-company
systems.)

In railroad bonds of this type, the location and strategic
value of the mileage covered are of prime importance. First-
mortgage bonds on nonessential and unprofitable parts of the
system, referred to sometimes as “ divisional liens,” are not true
underlying bonds in the sense that we have just used the term.
Divisional first liens on poorly located mileage may receive much
less favorable treatment in a ieorganization than blanket
mortgage bonds ostensibly junior to them.

Example: Central Branch Union Pacific Railway First 4s,
due 1938, were said to “underly” the Missouri Pacific First and
Refunding mortgage, which provided for their retirement.

SECURITY ANALYSIS

Yet the reorganization plans presented to the end of 1939 all
offered better treatment for the Missouri Pacific First and
Refunding 5s than for the ostensibly senior Central Branch
bonds.

As a practical matter it is not so easy to distinguish in advance
between the underlying bonds that come through reorganization
unscathed and those which suffer drastic treatment. Hence the
ordinary investor may be well advised to leave such issues out
of his calculations and stick to the rule that only strong com¬
panies have strong bonds.

CHAPTER VII

THE SELECTION OF FIXED-VALUE INVESTMENTS:
SECOND AND THIRD PRINCIPLES

n. BONDS SHOULD BE BOUGHT ON A DEPRESSION BASIS

The rule that a sound investment must be able to withstand
adversity seems self-evident enough to be termed a truism. Any
bond can do well when conditions are favorable; it is only under
the acid test of depression that the advantages of strong over
weak issues become manifest and vitally important. For this
reason prudent investors have always favored the obligations
of old-established enterprises which have demonstrated their
ability to come through bad times as well as good.

Presumption of Safety Based upon Either the Character of
the Industry or the Amount of Protection.—Confidence in the
ability of a bond issue to weather depression may be based on
either of two different reasons. The investor may believe that
the particular business will be immune from a drastic shrinkage
in earning power, or else that the margin of safety is so large that
it can undergo such a shrinkage without resultant danger. The
bonds of light and power companies have been favored principally
for the first reason, the bonds of United States Steel Corporation
subsidiaries for the second. In the former case it is the character
of the industry, in the latter it is the amount of protection, which
justifies the purchase. Of the two viewpoints, the one which
tries to avoid the perils of depression appeals most to the average
bond buyer. It seems much simpler to invest in a depression-
proof enterprise than to have to rely on the company’s financial
strength to pull its bonds through a period of poor results.

No Industry Entirely Depression-proof.—The objection to
this theory of investment is, of course, that there is no such
thing as a depression-proof industry, meaning thereby one that is
immune from the danger of any decline in earning power. It is
true that the Edison companies have shown themselves subject

SECURITY ANALYSIS

to only minor shrinkage in profits, as compared, say, with the
steel producers. But even a small decline may prove fatal if
the business is bonded to the limit of prosperity earnings. Once
it is admitted—as it always must be—that the industry can
suffer some reduction in profits, then the investor is compelled
to estimate the possible extent of the shrinkage and compare it
with the surplus above the interest requirements. He thus
finds himself in the same position as the holder of any other kind
of bond, vitally concerned with the ability of the company to
meet the vicissitudes of the future. 1

The distinction to be made, therefore, is not between industries
which are exempt from and those which are affected by depression,
but rather between those which are more and those which are
less subject to fluctuation. The more stable the type of enter¬
prise, the better suited it is to bond financing and the larger the
portion of the supposed normal earning power which may be
consumed by interest charges. As the degree of instability
increases, it must be offset by a greater margin of safety to make
sure that interest charges will be met; in other words, a smaller
portion of total capital may be represented by bonds. If there
is such a lack of inherent stability as to make survival of the
enterprise doubtful under continued unfavorable conditions (a
question arising frequently in the case of industrial companies
of secondary size), then the bond issue cannot meet the require¬
ments of fixed-value investment, even though the margin of
safety—measured by past performance—may be exceedingly
large. Such a bond will meet the quantitative but not the quali¬
tative test, but both are essential to our concept of investment. 8

Investment Practice Recognizes Importance of Character of
the Industry. —This conception of diverse margins of safety has
been solidly grounded in investment practice for many years.
The threefold classification of enterprises—as railroads, public
utilities, or industrials—was intended to reflect inherent differ¬
ences in relative stability and consequently in the coverage to be

1 Note that a large number of utility holding-company issues (and even
some overbonded operating companies) defaulted in 1931-1932, whereas
the subsidiary bonds of the* United States Steel Corporation maintained a
high investment rating despite the exceedingly bad operating results.

2 For examples of this important point, see our discussion of Studebaker
Preferred stock on p. 43 and of Willys-Overland Company First 6J^s on
p. 760,

FIXED-VALUE INVESTMENTS

required above bond interest requirements. Investors thought
well, for example, of any railroad which earned its bond interest
twice over, but the same margin in the case of an industrial bond
was ordinarily regarded as inadequate. In the decade between
1920 and 1930, the status of the public-utility division underwent
some radical changes. A sharp separation was introduced
between light, heat, and power services on the one hand, and
street-railway lines on the other, although previously the two had
been closely allied. The trolley companies, because of their poor
showing, were tacitly excluded from the purview of the term
“public utility,” as used in financial circles, and in the popular
mind the name was restricted to electric, gas, water, and tele-

COMPARISON OF RAILROAD AND PUBLIC-UTILITY GROSS AND NET WITH THE

Average Yield on High-grade Railroad and Utility Bonds
1926-1938 (Unit 81,000,000)

Year

Railroads

Public utilities

Gross 1

Net

railway

operating

income 2

Yield on
railroad
bonds, %*

Gross 4

Net 5

(index %)

Yield on
public-
utility
bonds, %*

$6,383

81,213

5.13

100 0

5.11

6,136

4.83

mamm

106.8

4.96

1928

6,112

1,173

1,784

124.0

4.87

mmm

5.18

■

142.5

5.14

■9

4.96

1,991

127.7

5.05

1931

4,188

526

6.09

123.5

5.27

3,127

326

1,814

96.6

6.30

3,095

474

1,755

98.2

6.25

1934

3,272

463

4.96

1,832

88.1

5.40

1935

3,452

4.95

1,912

92.9

4.43

1936

667

4.24

120.7

3.88

1937

■HU

4.34

2,181

125.8

3.93

1938

3,565

373

5.21

2,195

106.0

3.87

i Railway operating revenues for all Class I railroads in the United States (I.C.C.).

* Net railway operating income for the same roads (I.C.C.).

« Average yields on 40 rail and 40 utility bonds, respectively, as compiled by Moody’s.
4 Revenues from the sale of electric power to ultimate consumers, compiled by Edison
Electric Institute. Data from 00% of the industry are adjusted to cover 100% of the
industry (Survey of Current Business).

i Index of corporate profits of 15 publio utilities, compiled by Standard Statistics Com¬
pany, Inc. Figures are annual averages of quarterly relatives in whioh 1028 is the base

js*r.

SECURITY ANALYSIS

phone companies. (Later on, promoters endeavored to exploit
the popularity of the public utilities by applying this title to com¬
panies engaged in all sorts of businesses, including natural gas, ice,
coal, and even storage.) The steady progress of the utility
group, even in the face of the minor industrial setbacks of 1924
and 1927, led to an impressive advance in its standing among
investors, so that by 1929 it enjoyed a credit rating fully on a par
with the railroads. In the ensuing depression, it registered a
much smaller shrinkage in gross and net earnings than did the
transportation industry, and its seems logical to expect that bonds
of soundly capitalized light and power companies will replace
high-grade railroad bonds as the premier type of corporate
investment. (This seems true to the authors despite the distinct
recession in the popularity of utility bonds and stocks since 1933,
due to a combination of rate reductions, governmental competi¬
tion and threatened dangers from inflation.)

Depression Performance as a Test of Merit.—Let us turn our
attention now to the behavior of these three investment groups
in the two recent depression tests—that of 1931-1933 and that of
1937-1938. Of these, the former was of such unexampled sever¬
ity that it may seem unfair and impractical to ask that any
investment now under consideration should be measured by its
performance in those disastrous times. We have felt, however,
that the experiences of 1931-1933 may be profitably viewed as a
“laboratory test” of investment standards, involving degrees of
stress not to be expected in the ordinary vicissitudes of the future.
Even though the conditions prevalent in those years may not be
duplicated, the behavior of various types of securities at the time
should throw a useful light on investment problems.

Various Causes of Bond Collapses. 1 . 1Excessive Funded
Debt of Utilities .—If we study the bond issues which suffered
collapse in the post-bubble period, we shall observe that different
causes underlay the troubles of each group. The public-utility
defaults were caused not by a disappearance of earnings but by
the inability of overextended debt structures to withstand a
relatively moderate setback. Enterprises capitalized on a rea¬
sonably sound basis, as judged by former standards, had little
difficulty in meeting bond interest. This did not hold true in
the case of many holding companies with pyramided capital
structures which had absorbed nearly every dollar of peak-year

FIXED-VALUE INVESTMENTS

earnings for fixed charges and so had scarcely any margin avail¬
able to meet a shrinkage in profits. The widespread difficulties
of the utilities were due not to any weakness in the light and
power business , but to the reekless extravagance of its financing
methods. The losses of investors in public-utility bonds could
for the most part have been avoided by the exercise of ordinary
prudence in bond selection. Conversely, the unsound financing
methods employed must eventually have resulted in individual
collapses, even in the ordinary course of the business cycle. In
consequence, the theory of investment in sound public-utility
bonds appears in no sense to have been undermined by 1931-
1933 experience.

2. Stability of Railroad Earnings Overrated .—Turning to the
railroads, we find a somewhat different situation. Here the
fault appears to be that the stability of the transportation
industry was overrated, so that investors were satisfied with a
margin of protection which proved insufficient. It was not a
matter of imprudently disregarding old established standards
of safety, as in the case of the weaker utilities, but rather of
being content with old standards when conditions called for
more stringent requirements. Looking back, we can see that the
failure of the carriers generally to increase their earnings with
the great growth of the country since prewar days was a sign
of a weakened relative position, which called for a more cautious
and exacting attitude by the investor. If he had required his
railroad bonds to meet the same tests that he applied to industrial
issues, he would have been compelled to confine his selection to a
relatively few of the strongly situated lines. 1 As it turned out,
nearly all of these have been able to withstand the tremendous
loss of traffic since 1929 without danger to their fixed charges.
Whether or not this is a case of wisdom after the event is irrele¬
vant to our discussion. Viewing past experience as a lesson for

1 If, for example, the investor had restricted his attention to bonds of
roads which in the prosperous year 1928 covered their fixed charges
times or better, he would have confined his ^elections to bonds of: Atchison;
Canadian Pacific; Chesapeake and Ohio; Chicago, Burlington and Quincy;
Norfolk and Western; Pere Marquette; Reading; and Union Pacific. (With
the exception of Pere Marquette, the bonds of these roads fared compara¬
tively well in the depression. Note, however, that the foregoing test may be
more stringent than the one we propose later on: average earnings » twic*
fixed charges.)

SECURITY ANALYSIS

the future, we can see that selecting railroad bonds on a depression
basis would mean requiring a larger margin of safety in normal
times than was heretofore considered necessary.

The 1937-1938 Experience .—These conclusions with respect to
railroad and utility bonds are supported by the behavior of the
two groups in the 1937-1938 recession. Nearly all issues which
met reasonably stringent quantitative tests at the beginning of
1937 came through the ensuing slump with a relatively small
market decline and no impairment of inherent position. On
the other hand, bonds of both groups showing a substandard
earnings coverage for 1936 suffered in most cases a really serious
loss of quoted value, which in some instances proved the precursor
of financial difficulties for the issuer. 1

3. Depression Performance of Industrial Bonds .—In the case of
industrial obligations, the 1937-1938 pattern and the 1931-1933
pattern are appreciably different, so that the investors attitude
toward this type of security may depend somewhat on whether
he feels it necessary to guard against the more or the less serious
degree of depression. Studying the 1931-1933 record, we note
that price collapses were not due primarily to unsound financial
structures, as in the case of utility bonds, nor to a miscalculation
by investors as to the margin of safety needed, as in the case of
railroad bonds. We are confronted in many cases by a sudden
disappearance of earning power, and a disconcerting question as
to whether the business can survive. A company such as Gulf
States Steel, for example, earned its 1929 interest charges at
least 3)^ times in every year from 1922 to 1929. Yet in 1930
and 1931 operating losses were so large as to threaten its sol¬
vency. 2 Many basic industries, such as the Cuban sugar pro¬
ducers and our own coal mines, were depressed prior to the 1929
debacle. In the past, such eclipses had always proven to be
temporary, and investors felt justified in holding the bonds of
these companies in the expectation of a speedy recovery. But
in this instance the continuance of adverse conditions beyond
all previous experience defeated their calculations and destroyed
the values behind their investment.

1 See Appendix Note 11, p. 735, for a Bummary of the performance of
representative railroad and utility bonds in 1937-1938, as related to earnings
coverage for 1936.

* See Appendix Note 12, p. 736, for supporting data and other examples.

FIXED-VALUE INVESTMENTS

From these cases we must conclude that even a high margin
of safety in good times may prove ineffective against a succession
of operating losses caused by prolonged adversity. The difficul¬
ties that befell industrial bonds, therefore, cannot be avoided
in the future merely by more stringent requirements as to bond-
interest coverage in normal years.

If we examine more closely the behavior of the industrial bond
list in 1932-1933 (taking all issues listed on the New York Stock
Exchange), we shall note that the fraction that maintained a
price reflecting reasonable confidence in the safety of the issue
was limited to only 18 out of some 200 companies. 1

The majority of these companies were of outstanding impor¬
tance in their respective industries. This point suggests that
large size is a trait of considerable advantage in dealing with
exceptionally unfavorable developments in the industrial world,
which may mean in turn that industrial investments should be
restricted to major companies. The evidence, however, may be
objected to on the ground of having been founded on an admit¬
tedly abnormal experience. The less drastic test of 1937-1938
points rather towards the conventional conclusion that issues
strongly buttressed by past earnings can be relied on to with¬
stand depressions. 2 If, however, we go back over a longer period
—say, since 1915—we shall find perennial evidence of the
instability of industrial earning power. Even in the supposedly
prosperous period between 1922 and 1929, the bonds of smaller
industrial enterprises did not prove a dependable medium of
investment. There were many instances wherein an apparently
well-established earning power suffered a sudden disappearance. 3
In fact these unpredictable variations were sufficiently numerous

1 These companies were: American Machine and Foundry, American
Sugar Refining Company, Associated Oil Company, Corn Products Refining
Company, General Baking Company, General Electric Company, General
Motors Acceptance Corporation, Humble Oil and Refining Company,
International Business Machine Corporation, Liggett and Myers Tobacco
Company, P. Lorillard Company, National Sugar Refining Company,
Pillsbury Flour Mills Company, Smith (A.O.) Corporation, Socony-Vacuum
Corporation, Standard Oil Company of Indiana, Standard Oil Company of
New Jersey and United States Steel Corporation.

* Appendix Note 13, p. 737, summarizes the performance of Industrial
bonds in 1937-1938, as related to earnings for a period ended in 1936.

# See Appendix Note 14, p. 737, for examples.

SECURITY ANALYSIS

to suggest the conclusion that there is an inherent lack of stability
in the small or medium-sized industrial enterprise, which makes
them ill-suited to bond financing. A tacit recognition of this
weakness has been responsible in part for the growing adoption of
conversion and subscription-warrant privileges in connection
with industrial-bond financing. 1 To what extent such embellish¬
ments can compensate for insufficient safety will be discussed
in our chapters on Senior Securities with Speculative Features.
But in any event the widespread resort to these profit-sharing
artifices seems to confirm our view that bonds of smaller industrial
companies are not well qualified for consideration as fixed-value
investments.

Unavailability of Sound Bonds No Excuse for Buying Poor
Ones. —However, if we recommend that straight bond invest¬
ment in the industrial field be confined to companies of dominant
size, we face the difficulty that such companies are few in number
and many of them have no bonds outstanding. It may be
objected further that such an attitude would severely handicap
the financing of legitimate businesses of secondary size and
would have a blighting effect on investment-banking activities.
The answer to these remonstrances must be that no consideration
can justify the purchase of unsound bonds at an investment
price. The fact that no good bonds are available is hardly an
excuse for either issuing or accepting poor ones. Needless to
say, the investor is never forced to buy a security of inferior
grade. At some sacrifice in yield he can always find issues that
meet his requirements, however stringent; and, as we shall point
out later, attempts to increase yield at the expense of safety
are likely to prove unprofitable. From the standpoint of the
corporations and their investment bankers, the conclusion must
follow that if their securities cannot properly qualify as straight
investments, they must be given profit-making possibilities
sufficient to compensate the purchaser for the risk he runs.

Conflicting Views on Bond Financing.—In this connection,
observations are in order regarding two generally accepted ideas
on the subject of bond financing. The first is that bond issues
are an element of weakness in a company’s financial position, so
that the elimination of funded debt is always a desirable object.
The second is that when companies are unable to finance through

1 See footnote 1, p. 286.

FIXED-VALUE INVESTMENTS

the sale of stock it is proper to raise money by means of bond
issues. In the writers' view both of these widespread notions
are quite incorrect. Otherwise there would be no really sound
basis for any bond financing. For they imply that only weak
companies should be willing to sell bonds—which, if true, would
mean that investors should not be willing to buy them.

Proper Theory of Bond Financing.—The proper theory of
bond financing, however, is of quite different import. A reason¬
able amount of funded debt is of advantage to a prosperous
business, because the stockholders can earn a profit above
interest charges through the use of the bondholders' capital. It
is desirable for both the corporation and the investor that the
borrowing be limited to an amount which can safely be taken
care of under all conditions. Hence, from the standpoint of
sound finance, there is no basic conflict of interest between the
strong corporation which floats bonds and the public which buys
them. On the other hand, whenever an element of unwillingness
or compulsion enters into the creation of a bond issue by an
enterprise, these bonds are ipso facto of secondary quality and
it is unwise to purchase them on a straight investment basis.

Unsound Policies Followed in Practice.—Financial policies
followed by corporations and accepted by the public have for
many years run counter to these logical principles. The rail¬
roads, for example, have financed the bulk of their needs through
bond sales, resulting in an overbalancing of funded debt as
against stock capital. This tendency has been repeatedly
deplored by all authorities, but accepted as inevitable because
poor earnings made stock sales impracticable. But if the latter
were true, they also made bond purchases inadvisable. It is
now quite clear that investors were imprudent in lending money
to carriers which themselves complained of the necessity of
having to borrow it.

While investors were thus illogically lending money to weak
borrowers, many strong enterprises were paying off their debts
through the sale of additional stock. But if there is any thor¬
oughly sound basis for corporate borrowing, then this procedure
must also be regarded as unwise. If a reasonable amount of
borrowed capital, obtained at low interest rates, is advantageous
to the stockholder, then the replacement of this debt by added
stock capital means the surrender of such advantage. The

100

SECURITY ANALYSIS

elimination of debt will naturally simplify the problems of
the management, but surely there must be some point at which the
return to the stockholders must also be considered. Were this
not so, corporations would be constantly raising money from their
owners and they would never pay any part of it back in dividends.
It should be pointed out that the mania for debt retirement in
1927-1929 has had a disturbing effect upon our banking situation,
since it eliminated most of the good commercial borrowers and
replaced them by second-grade business risks and by loans on
stock collateral, which were replete with possibilities of harm.

Significance of the Foregoing to the Investor.—The above
analysis of the course of industrial bond borrowing in the last
15 years is not irrelevant to the theme of this chapter, viz., the
application of depression standards to the selection of fixed-
value investments. Recognizing the necessity of ultra-stringent
criteria of choice in the industrial field, the bond buyer is faced
by a further narrowing of eligible issues due to the elimination
of funded debt by many of the strongest companies. Clearly
his reaction must not be to accept the issues of less desirable
enterprises, in the absence of better ones, but rather to refrain
from any purchases on an investment basis if the suitable ones
are not available. It appears to be a financial axiom that
whenever there is money to invest, it is invested; and if the owner
cannot find a good security yielding a fair return, he will invari¬
ably buy a poor one. But a prudent and intelligent investor
should be able to avoid this temptation, and reconcile himself
to accepting an unattractive yield from the best bonds, in
preference to risking his principal in second-grade issues for the
sake of a large coupon return.

Summary.—The rule that bonds should be bought on the
basis of their ability to withstand depression has been part of
an old investment tradition. It was nearly lost sight of in the
prosperous period culminating in 1929, but its importance was
made painfully manifest during the following collapse and
demonstrated again in the 1937-1938 recession. The bonds
of reasonably capitalized electric and gas companies have
given a satisfactory account of themselves during this decade
and the same is true—to a lesser degree—of the relatively few
railroads which showed a large margin above interest charges
prior to 1930. In the industrial list, however, even an excellent

FIXED-VALUE INVESTMENTS

101

past record has in many cases proved undependable, especially
where the company is of small or moderate size. For this reason,
the investor would seem to gain better protection against adverse
developments by confining his industrial selections to companies
which meet the two requirements of (1) dominant size and
(2) substantial margin of earnings over bond interest.

m. THIRD PRINCIPLE: UNSOUND TO SACRIFICE
SAFETY FOR YIELD

In the traditional theory of bond investment a mathematical
relationship is supposed to exist between the interest rate and
the degree of risk incurred. The interest return is divided into
two components, the first constituting “pure interest”— i.e., the
rate obtainable with no risk of loss—and the second representing
the premium obtained to compensate for the risk assumed. If,
for example, the “pure interest rate” is assumed to be 2%, then
a 3 % investment is supposed to involve one chance in a hundred
of loss, while the risk incurred in an 7% investment would be
five times as great, or 1 in 20. (Presumably the risk should be
somewhat less than that indicated, to allow for an “insurance
profit.”)

This theory implies that bond-interest rates are closely similar
to insurance rates, and that they measure the degree of risk on
some reasonably precise actuarial basis. It would follow that,
by and large, the return from high- and low-yielding investments
should tend to equalize, since what the former gain in income
would be offset by their greater percentage of principal losses,
and vice versa.

No Mathematical Relationship between Yield and Risk.—

This view, however, seems to us to bear little relation to the
realities of bond investment. Security prices and yields are
not determined by any exact mathematical calculation of the
expected risk, but they depend rather upon the popularity of the
issue. This popularity reflects in a general way the investors'
view as to the risk involved, but it is also influenced largely by
other factors, such as the degree of familiarity of the public with
the company and the issue (seasoning) and the ease with which
the bond can be sold (marketability).

It may be pointed out further that the supposed actuarial
computation of investment risks is out of the question theoreti-

102

SECURITY ANALYSIS

cally as well as in practice. There are no experience tables
available by which the expected “mortality” of various types of
issues can be determined. Even if such tables were prepared,
based on long and exhaustive studies of past records, it is doubtful
whether they would have any real utility for the future. In life
insurance the relation between age and mortality rate is well
defined and changes only gradually. The same is true, to a
much lesser extent, of the relation between the various types of
structures and the fire hazard attaching to them. But the rela¬
tion between different kinds of investments and the risk of loss
is entirely too indefinite, and too variable with changing condi¬
tions, to permit of sound mathematical formulation. This is
particularly true because investment losses are not distributed
fairly evenly in point of time, but tend to be concentrated at
intervals, i.e. } during periods of general depression. Hence
the typical investment hazard is roughly similar to the conflagra¬
tion or epidemic hazard, which is the exceptional and incalculable
factor in fire or life insurance.

Self-insurance Generally Not Possible in Investment.—If we

were to assume that a precise mathematical relationship does
exist between yield and risk, then the result of this premise
should be inevitably to recommend the lowest yielding—and
therefore the safest—bonds to all investors. For the individual
is not qualified to be an insurance underwriter. It is not his
function to be paid for incurring risks; on the contrary it is to
his interest to pay others for insurance against loss. Let us
assume a bond buyer has his choice of investing $1,000 for $20
per annum without risk, or for $70 per annum with 1 chance
out of 20 each year that his principal would be lost. The $50
additional income on the second investment is mathemati¬
cally equivalent to the risk involved. But in terms of 'personal
requirements , an investor cannot afford to take even a small
chance of losing $1,000 of principal in return for an extra $50 of
income. Such a procedure would be the direct opposite of the
standard procedure of paying small annual sums to protect prop¬
erty values against loss by fire and theft.

The Factor of Cyclical Risks. —The investor cannot prudently
turn himself into an insurance company and incur risks of losing
his principal in exchange for annual premiums in the form of
extra-large interest coupons. One objection to such a policy

FIXED-VALUE INVESTMENTS

103

is that sound insurance practice requires a very wide distribution
of risk, in order to minimize the influence of luck and to allow
maximum play to the law of probability. The investor may
endeavor to attain this end’ by diversifying his holdings, but
as a practical matter he cannot approach the division of risk
attained by an insurance company. More important still is the
danger that many risky investments may collapse together in a
depression period, so that the investor in high-yielding issues will
find a period of large income (which he will probably spend)
followed suddenly by a deluge of losses of principal.

It may be contended that the higher yielding securities on the
whole return a larger premium above “pure interest” than the
degree of risk requires; in other words, that in return for taking
the risk, investors will in the long run obtain a profit over and
above the losses in principal suffered. It is difficult to say
definitely whether or not this is true. But even assuming that
the high coupon rates will, in the great aggregate, more than
compensate on an actuarial basis for the risks accepted, such
bonds are still undesirable investments from the personal stand¬
point of the average investor. Our arguments against the inves¬
tor turning himself into an insurance company remain valid even
if the insurance operations all told may prove profitable. The
bond buyer is neither financially nor psychologically equipped
to carry on extensive transactions involving the setting up of
reserves out of regular income to absorb losses in substantial
amounts suffered at irregular intervals.

Risk and Yield Are Incommensurable.—The foregoing dis¬
cussion leads us to suggest the principle that income return and
risk of principal should be regarded as incommensurable . Prac¬
tically speaking, this means that acknowledged risks of losing
principal should not be offset merely by a high coupon rate, but
can be accepted only in return for a corresponding opportunity
for enhancement of principal, e.g through the purchase of bonds
at a substantial discount from par, or possibly by obtaining an
unusually attractive conversion privilege. While there may be
no real mathematical difference between offsetting risks of loss
by a higher income or by a chance for profit, the psychological
difference is very important. The purchaser of low-priced bonds
is fully aware of the risk he is running; he is more likely to make
a thorough investigation of the issue and to appraise carefully

104

SECURITY ANALYSIS

the chances of loss and of profit; finally—most important of all
—he is prepared for whatever losses he may sustain, and his
profits are in a form available to meet his losses. Actual invest¬
ment experience, therefore, will not favor the purchase of the
typical high-coupon bond offered at about par, wherein, for
example, a 7% interest return is imagined to compensate for a
distinctly inferior grade of security. 1

Fallacy of the “Business Man’s Investment.”—An issue of
this type is commonly referred to in the financial world as a
“business man’s investment” and is supposedly suited to those
who can afford to take some degree of risk. Most of the foreign
bonds floated between 1923 and 1929 belonged in that category.
The same is true of the great bulk of straight preferred stock
issues. According to our view, such “business man's invest¬
ments” are an illogical type of commitment. The security buyer
who can afford to take some risk should seek a commensurate
opportunity of enhancement in price and pay only secondary
attention to the income obtained.

Reversal of Customary Procedure Recommended.—Viewing
the matter more broadly, it would be well if investors reversed
their customary attitude toward income return. In selecting
the grade of bonds suitable to their situation, they are prone to
start at the top of the list, where maximum safety is combined
with lowest yield, and then to calculate how great a concession
from ideal security they are willing to make for the sake of a
more attractive income rate. From this point of view, the ordi¬
nary investor becomes accustomed to the idea that the type of
issue suited to his needs must rank somewhere below the very
best, a frame of mind which is likely to lead to the acceptance
of definitely unsound bonds, either because of their high income
return or by surrender to the blandishments of the bond salesman.

It would be sounder procedure to start with minimum stand¬
ards of safety, which all bonds must be required to meet in order
to be eligible for further consideration. Issues failing to meet
these minimum requirements should be automatically disquali¬
fied as straight investments, regardless of high yield, attractive
prospects, or other grounds for partiality. Having thus delimited
the field of eligible investments, the buyer may then apply such

1 In an exceptional year such as 1921 strongly entrenched bonds were
offered bearing a 7 % coupon, due to the prevailing high money rates.

FIXED-VALVE INVESTMENTS

105

further selective processes as he deems appropriate. He may
desire elements of safety far beyond the accepted minima, in
which case he must ordinarily make some sacrifice of yield. He
may also indulge his preferences as to the nature of the business
and the character of the management. But, essentially, bond
selection should consist of working upward from definite mini¬
mum standards rather than working downward in haphazard
fashion from some ideal but unacceptable level of maximum
security.

CHAPTER VIII

SPECIFIC STANDARDS FOR BOND INVESTMENT

IV. FOURTH PRINCIPLE: DEFINITE STANDARDS OF SAFETY
MUST BE APPLIED

Since the selection of high-grade bonds has been shown to
be in good part a process of exclusion, it lends itself reasonably
well to the application of definite rules and standards designed
to disqualify unsuitable issues. Such regulations have in fact
been set up in many states by legislative enactment to govern
the investments made by savings banks and by trust funds. In
most such states, the banking department prepares each year a
list of securities which appear to conform to these regulations
and are therefore considered “ legal,” i.e ., eligible for purchase
under the statute.

It is our view that the underlying idea of fixed standards and
minima should be extended to the entire field of straight invest¬
ment, i.e., investment for income only. These legislative
restrictions are intended to promote a high average level of
investment quality and to protect depositors and beneficiaries
against losses from unsafe securities. If such regulations are
desirable in the case of institutions, it should be logical for
individuals to follow them also. We have previously challenged
the prevalent idea that the ordinary investor can afford to take
greater investment risks than a savings bank, and need not
therefore be as exacting with respect to the soundness of his
fixed-value securities. The experience since 1928 undoubtedly
emphasizes the need for a general tightening of investment
standards, and a simple method of attaining this end might be
to confine all straight-bond selections to those which meet the
legal tests of eligibility for savings banks or trust funds. Such a
procedure would appear directly consonant with our fundamental
principle that straight investments should be made only in issues
of unimpeachable soundness, and that securities of inferior grade
must be bought only on an admittedly speculative basis.

106

FIXED-VALUE INVESTMENTS

107

New York Savings-bank Law as a Point of Departure.— As a

matter of practical policy , an individual bond buyer is likely to
obtain fairly satisfactory results by subjecting himself to the
restrictions which govern the‘investment of savings banks’ funds.
But this procedure cannot be seriously suggested as a general
principle of investment , because the legislative provisions are
themselves far too imperfect to warrant their acceptance as the
best available theoretical standards. The acts of the various
states are widely divergent; most of them are antiquated in
important respects; none is entirely logical or scientific. The
legislators did not approach their task from the viewpoint of
establishing criteria of sound investments for universal use;
consequently they felt free to impose arbitrary restrictions on
savings-bank and trust funds, which they would have hesitated
to prescribe for investors generally. The New York statute,
generally regarded as the best of its class, is nevertheless marred
by a number of evident defects. In the formulation of compre¬
hensive investment standards, the New York legislation may best
be used, therefore, as a guide or point of departure, rather than
as a final authority. The ensuing discussion will follow fairly
closely the pattern set forth in the statutory provisions (as they
existed in 1939); but these will be criticized, rejected, or ampli¬
fied, whenever such emendation appears desirable.

GENERAL CRITERIA PRESCRIBED BY THE NEW YORK STATUTE

The specific requirements imposed by the statute upon bond
investments may be classified under seven heads, which we shall
proceed to enumerate and discuss:

1. The nature and location of the business or government.

2. The size of the enterprise, or the issue.

3. The terms of the issue.

4. The record of solvency and dividend payments.

5. The relation of earnings to interest requirements.

6. The relation of the value of the property to the funded debt.

7. The relation of stock capitalization to the funded debt.

NATURE AND LOCATION

The most striking features of the laws governing savings-bank
investments is the complete exclusion of bonds in certain broad
categories. The New York provisions relative to permitted and

108

SECURITY ANALYSIS

prohibited classes may be summarized as follows (subject to a
1938 amendment soon to be discussed):

Admitted

United States government, state and
municipal bonds.

Railroad bonds and electric, gas and
telephone mortgage bonds.

Bonds secured by first mortgages on
real estate.

Excluded

Foreign government and foreign
corporation bonds.

Street railway and water bonds.
Debentures of public utilities.

All industrial bonds.

Bonds of financial companies (in¬
vestment trusts, credit concerns,
etc.).

The Fallacy of Blanket Prohibitions. —The legislature was
evidently of the view that bonds belonging to the excluded cate¬
gories are essentially too unstable to be suited to savings-bank
investment. If this view is entirely sound, it would follow from
our previous reasoning that all issues in these groups are unsuited
to conservative investment generally. Such a conclusion would
involve revolutionary changes in the field of finance, since a large
part of the capital now regularly raised in the investment market
would have to be sought on an admittedly speculative basis.

In our opinion, a considerable narrowing of the investment
category is in fact demanded by the unsatisfactory experience of
bond investors over a fairly long period. Nevertheless, there
are strong objections to the application of blanket prohibitions
of the kind now under discussion. Investment theory should
be chary of easy generalizations. Even if full recognition is
given, for example, to the unstable tendencies of industrial bonds,
as discussed in Chap. VII, the elimination of this entire major
group from investment consideration would seem neither prac¬
ticable nor desirable. The existence of a fair number of indus¬
trial issues (even though a small percentage of the total) which
have maintained an undoubted investment status through the
severest tests, would preclude investors generally from adopting
so drastic a policy. Moreover, the confining of investment
demand to a few eligible types of enterprise is likely to make for
scarcity, and hence for the acceptance of inferior issues merely
because they fall within these groups. This has in fact been one
of the unfortunate results of the present legislative restrictions.

Individual Strength May Compensate for Inherent Weakness
of a Class. —It would seem a sounder principle, therefore, to

FIXED-VALUE INVESTMENTS

109

require a stronger exhibit by the individual bond to compensate
for any weakness supposedly inherent in its class, rather than to
seek to admit all bonds of certain favored groups and to exclude
all bonds of others. An industrial bond may properly be required
to show a larger margin of earnings over interest charges and a
smaller proportion of debt to going-concern value than would
be required of an obligation of a gas or electric enterprise. The
same would apply in the case of traction bonds. In connection
with the exclusion of water-company bonds by the New York
statute, it should be noted that this group is considered by most
other states to be on a par with gas, electric, and telephone
obligations. There seems to be no good reason for subjecting
them to more stringent requirements than in the case of other
types of public-service issues.

The 1938 Amendment to the Banking Law.—In 1938 the New
York legislature, recognizing the validity of these objections to
categorical exclusions, proceeded to relieve the situation in a
rather peculiar manner. It decreed that the Banking Board could
authorize savings banks to invest in interest-bearing obligations
not otherwise eligible for investment, provided application for
such authorization shall have been made by not less than 20 sav¬
ings banks, or by a trust company, all of the capital stock of
which is owned by not less than 20 savings banks. (This meant
the Savings Bank Trust Company of New York.)

Clearly this amendment goes much farther than a mere widen¬
ing of the categories of savings-bank investment. What it does,
in fact, is to supersede—potentially, at least—all the specific
requirements of the law (other than the primary insistence on
interest-paying bonds) by the combined judgment of the savings
banks themselves and the Banking Board. This means that, in
theory, all seven of the criteria imposed by the law may be set
aside by agreement of the parties. Obviously there is no prac¬
tical danger that the legislative wisdom of the statute will be
completely flouted. In fact, investments authorized by virtue
of this new provision up to the end of 1939 are all unexception¬
able in character. They include previously ineligible debenture
issues of very strong telephone and industrial companies. (Curi¬
ously enough, no industrial mortgage bond has as yet been
approved, but this may serve to confirm our previous statement
that good industrial bonds are likely to be debentures.)

SECURITY ANALYSIS

The action to date under the 1938 amendment has represented
a praiseworthy departure from the unduly narrow restrictions of
the statute itself, which we have criticized above. We are by no
means convinced, however, that the legislation as it now stands
is in really satisfactoiy form. There seems to be something
puerile about enacting a long list of rules and then permitting an
administrative body to waive as many of them as it sees fit.
Would it not be better to prescribe a few really important criteria,
which must be followed in every instance, and then give the
Banking Board discretionary power to exclude issues that meet
these minimum requirements but still are not sound enough in
its conservative judgment?

Obligations of Foreign Governments.—We have argued
against any broad exclusions of entire categories of bonds. But
in dealing with foreign-government debts, a different type of
reasoning may conceivably be justified. Such issues respond in
but small degree to financial analysis, and investment therein is
ordinarily based on general considerations, such as confidence in
the country's economic and political stability and the belief
that it will faithfully endeavor to discharge its obligations.
To a much greater extent, therefore, than in the case of other
bonds, an opinion may be justified or even necessitated as to the
general desirability of foreign-government bonds for fixed-value
investment.

The Factor of Political Expediency .—Viewing objectively the
history of foreign-bond investment in this country since it first
assumed importance during the World War, it is difficult to
escape an unfavorable conclusion on this point. In the final
analysis, a foreign-government debt is an unenforceable contract.
If payment is withheld, the bondholder has no direct remedy.
Even if specific revenues or assets are pledged as security, he is
practically helpless in the event that these pledges are broken. 1
It follows that while a foreign-government obligation is in theory
a claim against the entire resources of the nation, the extent

1 Among the numerous examples of this unhappy fact we may mention
the pledge of specific revenues behind the Dawes Loan (German government)
7s, due 1949, and the Sao Paulo Secured 7s, due 1956. Following default
of service of these two loans in 1934 and 1932, respectively, nothing whatever
was done, or could have been done, to enforce the claim against the pledged
revenues.

FIXED-VALUE INVESTMENTS

111

to which these resources are actually drawn upon to meet the
external debt burden is found to depend in good part on political
expediency. The grave international dislocations of the post¬
war period made some defaults inevitable, and supplied the
pretext for others. In any event, because nonpayment has
become a familiar phenomenon, its very frequency has removed
much of the resultant obloquy. Hence the investor has, seem¬
ingly, less reason than of old to rely upon herculean efforts being
made by a foreign government to live up to its obligations during
difficult times.

The Foreign-trade Argument. —It is generally argued that a
renewal of large-scale international lending is necessary to restore
world equilibrium. More concretely, such lending appears to be
an indispensable adjunct to the restoration and development of
our export trade. But the investor should not be expected to
make unsound commitments for idealistic reasons or to benefit
American exporters. As a speculative operation , the purchase
of foreign obligations at low prices, such as prevailed in 1932,
might prove well justified by the attendant possibilities of
profit; but these tremendously depreciated quotations are in
themselves a potent argument against later purchases of new
foreign issues at a price close to 100% of face value, no matter
how high the coupon rate may be set.

The Individual-record Argument. —It may be contended, how¬
ever, that investment in foreign obligations is essentially similar
to any other form of investment in that it requires discrimina¬
tion and judgment. Some nations deserve a high credit rating
based on their past performance, and these are entitled to invest¬
ment preference to the same degree as arc domestic corporations
with satisfactory records. The legislatures of several states have
recognized the superior standing of Canada by authorizing sav¬
ings banks to purchase its obligations, and Vermont has accepted
also the dollar bonds of Belgium, Denmark, Great Britain, Hol¬
land, and Switzerland.

A strong argument in the contrary direction is supplied by the
appended list of the various countries having debts payable in
dollars, classified according to the credit rating indicated by
the market action of their bonds during the severe test of 1932.

1. Countries whose bonds sold on an investment basis: Canada, France,
Great Britain, Netherlands, Switzerland.

112

SECURITY ANALYSIS

2. Countries whose bonds sold on a speculative basis: Argentina, Aus¬
tralia, Austria, Bolivia, Brazil, Bulgaria, Chile, China, Colombia, Costa
Rica, Cuba, Czecho-Slovakia, Denmark, Dominican Republic, Esthonia,
Finland, Germany, Guatemala, Greece, Haiti, Hungary, Japan, Jugoslavia,
Mexico, Nicaragua, Panama, Peru, Poland, Rumania, Russia, Salvador,
Uruguay.

3. Borderline countries: Belgium, Ireland, Italy, Norway, Sweden.

Of the five countries in the first or investment group, the
credit of two, viz ., France and Great Britain, was considered
speculative in the preceding depression of 1921-1922. Out of
42 countries represented, therefore, only three (Canada, Holland,
and Switzerland) enjoyed an unquestioned investment rating
during the twelve years ending in 1932.

Twofold Objection to Purchase of Foreign-government Bonds .—
This evidence suggests that the purchase of foreign-government
bonds is subject to a twofold objection of generic character:
theoretically, in that the basis for credit is fundamentally
intangible; and practically, in that experience with the foreign
group has been preponderantly unsatisfactory. Apparently
it will require a considerable betterment of world conditions,
demonstrated by a fairly long period of punctual discharge of
international obligations, to warrant a revision of this unfavorable
attitude toward foreign bonds as a class.

Canadian issues may undoubtedly be exempted from this
blanket condemnation, both on their record and because of the
closeness of the relationship between Canada and the United
States. Individual investors, for either personal or statistical
reasons, may be equally convinced of the high credit standing
of various other countries, and will therefore be ready to pur¬
chase their obligations as high-grade investments. Such com¬
mitments may prove to be fully justified by the facts; but for
some years, at least, it would be well if the investor approached
them in the light of exceptions to a general rule of avoiding
foreign bonds, and required them accordingly to present excep¬
tionally strong evidence of stability and safety. 1

l The foregoing section relating to foreign-government bonds is repro¬
duced without change from the 1934 edition of this work. War conditions
existing in 1940 add emphasis to our conclusions. Note that at the end of
1939 the dollar bonds of only Argentina, Canada and Cuba were selling on
better than a 6 % basis in our markets. (Certain Cuban bonds were selling
to yield over 6 %. Note also that Great Britain, Netherlands. Sweden and

FIXED-VALUE INVESTMENTS

113

Bonds of Foreign Corporations, —In theory , bonds of a corpora¬
tion, however prosperous, cannot enjoy better security than the
obligations of the country in which the corporation is located.
The government, through its* taxing power, has an unlimited
prior claim upon the assets and earnings of the business; in
other words, it can take the property away from the private
bondholder and utilize it to discharge the national debt. But
in actuality, distinct limits are imposed by political expediency
upon the exercise of the taxing power. Accordingly we find
instances of corporations meeting their dollar obligations even
when their government is in default. 1

Foreign-corporation bonds have an advantage over govern¬
mental bonds in that the holder enjoys specific legal remedies
in the event of nonpayment, such as the right of foreclosure.
Consequently it is probably true that a foreign company is
under greater compulsion to meet its debt than is a sovereign
nation. But it must be recognized that the conditions resulting
in the default of government obligations are certain to affect
adversely the position of the corporate bondholder. Restric¬
tions on the transfer of funds may prevent the payment of
interest in dollars even though the company may remain amply
solvent. 2 Furthermore, the distance separating the creditor
from the property, and the obstacles interposed by governmental
decree, are likely to destroy the practical value of his mortgage
security. For these reasons the unfavorable conclusions reached
with respect to foreign-government obligations as fixed-value
investments must be considered as applicable also to foreign-
corporation bonds.

SIZE

The bonds of very small enterprises are subject to objections
which disqualify them as media for conservative investment.
A company of relatively minor size is more vulnerable than others
to unexpected happenings, and it is likely to be handicapped by
the lack of strong banking connections or of technical resources.

Switzerland had no dollar bonds outstanding.) For data concerning foreign-
bond defaults see various news releases and reports of Foreign Bondholders*
Protective Council, Inc.

1 See Appendix Note 15, p. 738, for examples.

* See Appendix Note 16, p. 730, for examples.

114

SECURITY ANALYSIS

Very small businesses, therefore, have never been able to obtain
public financing and have depended on private capital, those
supplying the funds being given the double inducement of a share
in the profits and a direct voice in the management. The objec¬
tions to bonds of undersized corporations apply also to tiny
villages or microscopic townships, and the careful investor in
municipal obligations will ordinarily avoid those below a certain
population level.

The establishment of such minimum requirements as to size
necessarily involves the drawing of arbitrary lines of demarca¬
tion. There is no mathematical means of determining exactly
at what point a company or a municipality becomes large enough
to warrant the investors attention. The same difficulty will
attach to setting up any other quantitative standards, as for
example the margin of earnings above interest charges, or the
relation of stock or property values to bonded debt. It must be
borne in mind, therefore, that all these “critical points” arc
necessarily rule-of-thumb decisions, and the investor is free to
use other amounts if they appeal to him more. But however
arbitrary the standards selected may be, they are undoubtedly
of great practical utility in safeguarding the bond buyer from
inadequately protected issues.

Provisions of New York Statute.—The New York statute has
prescribed various standards as to minimum size in defining
investments eligible for savings banks. As regards municipal
bonds, a population of not less than 10,000 is required for states
adjacent to New York, and of 30,000 for other states. Railroads
must either own 500 miles of standard-gauge line or else have
operating revenues of not less than $10,000,000 per annum.
Unsecured and income bonds of railroad companies arc admitted
only if (among other special requirements) the net income avail¬
able for dividends amounts to $10,000,000. For gas and electric
companies, gross revenues must have averaged $1,000,000 per
year during the preceding five years; but in the case of telephone
bonds, this figure must be $5,000,000. There are further
provisions to the effect that the size of the bond issue itself must
be not less than $1,000,000 for gas and electric companies, and
not less than $5,000,000 in the case of telephone obligations.

Some Criticisms of These Requirements .—The figures of
minimum gross receipts do not appear well chosen from the

FIXED-VALUE INVESTMENTS

115

standpoint of bond investment in general. The distinctions as
to population requirements would scarcely appeal to investors
throughout the country. The alternative tests for railroads,
based on either mileage or revenues, are confusing and unneces¬
sary. The $10,000,000-gross requirement by itself is too high;
it would have eliminated, for example, the Bangor and Aroostock
Railroad, one of the few lines to make a satisfactory exhibit
during the 1930-1933 depression as well as before. Equally
unwarranted is the requirement of $5,000,000 gross for telephone
concerns, as against only $1,000,000 for gas and electric utilities.
This provision would have ruled out the bonds of Tri-State
Telephone and Telegraph Company prior to 1927, although they
were then (and since) obligations of unquestioned merit. We
believe that the following proposed requirements for minimum
size, although by necessity arbitrarily taken, arc in reasonable
accord with the realities of sound investment:

Minimum Requirement of Size

Municipalities. 10.000 population

Public-utility enterprises . $2,000,000 gross

Railroad systems. $3,000,000 gross

Industrial companies. $5,000,000 gross

Industrial Bonds and the Factor of Size.—Since industrial
bonds are not eligible for savings banks under the New York
law, no minimum size is therein prescribed. We have expressed
the view that industrial obligations may be included among
high-grade investments provided they meet stringent tests of
safety. The experience of the past decade indicates that
dominant or at least substantial size affords an element of
protection against the hazards of instability to which industrial
enterprises are more subject than arc railroads or public utilities.
A cautious investor, seeking to profit from recent lessons, would
apparently be justified in deciding to confine his purchases of
fixed-value bonds to perhaps the half dozen leading units in each
industrial group, and also perhaps in adding the suggested
minimum requirement of $5,000,000 annual sales.

Such minimum standards may be criticized as unduly string¬
ent, in that if they were universally applied (which in any
event is unlikely) they would make it impossible for sound and
prosperous businesses of moderate size to finance themselves
through straight bond issues. It is conceivable that a general

116

SECURITY ANALYSIS

stabilization of industrial conditions in the United States may
invalidate the conclusions derived from the extreme variations
of the past ten years. But until such a tendency in the direction
of stability has actually demonstrated itself, we should favor
a highly exacting attitude toward the purchase of industrial
bonds at investment levels.

Large Size Alone No Guarantee of Safety.—These recom¬
mendations on the subject of minimum size do not imply that
enormous dimensions are in themselves a guarantee of prosperity
and financial strength. The biggest company may be the
weakest if its bonded debt is disproportionately large. More¬
over, in the railroad, public-utility, and municipal groups, no
practical advantage attaches to the very largest units as com¬
pared with those of medium magnitude. Whether the gross
receipts of an electric company are twenty millions or a hundred
millions has, in all probability, no material effect on the safety
of its bonds; and similarly a town of 75,000 inhabitants may
deserve better credit than would a city of several millions.
It is only in the industrial field that we have suggested that the
bonds of a very large enterprise may be inherently more desirable
than those of middle-sized companies; but even here a thoroughly
satisfactory statistical showing on the part of the large company
is necessary to make this advantage a dependable one.

Other Provisions Rejected. —The New York statute includes
an additional requirement in respect to unsecured railroad bonds,
viz ., that the net earnings after interest charge must equal
$10,000,000. This does not appear to us to be justified, since
we have previously argued against attaching particular sig¬
nificance to the possession or lack of mortgage security. There
is a certain logical fallacy also in the further prescription of a
minimum size for the bond issue itself in the case of public
utilities. If the enterprise is large enough as measured by its
gross business, then the smaller the bond issue the easier it
would be to meet interest and principal requirements. The
legislature probably desired to avoid the inferior marketability
associated with very small issues. In our view, the element of
marketability is generally given too much stress by investors;
and in this case we do not favor following the statutory require¬
ment with respect to the size of the issue as a general rule for
bond investment.

CHAPTER IX

SPECIFIC STANDARDS FOR BOND INVESTMENT

(Continued)

THE PROVISIONS OF THE ISSUE

Under this heading come such features as the security of
the bonds, the conditions affecting interest payments, and the
date of maturity. Conversion and similar privileges, specified
in the indenture, arc, of course, important in themselves, but
they do not enter into the determination of standards for the
selection of fixed-value investments.

Under the New York statute, only bonds secured by mortgage
are eligible in the public-utility group. 1 However, debenture
(unsecured) railroad bonds are admitted, provided the earnings
and dividend record meet stiffer requirements than are set forth
for mortgage issues. The statute also permits the purchase
of income bonds (i.e., those on which the obligation to pay inter¬
est is dependent upon earnings) on the same basis as debentures.

Obsolete and Illogical Restrictions.—In our opinion this set
of restrictions is quite out of date and illogical. In view of our
emphatic argument in Chap. VI against attaching predominant
weight to specific security, it must be clear that we do not favor
the exclusion of any group of unsecured bond issues per se , or
even the establishment of any sharply defined standards or
requirements which favor secured bonds over debentures.

If a company has only one bond issue, it would seem to make
little difference whether this is a first mortgage or a debenture,
provided the latter is protected against the placing of future
issues ahead of it. Needless to say, a debenture bond preceded
by a first mortgage is not so attractive as the first-mortgage bond
itself, even though the investor’s chief reliance in both cases

1 The specific provisions of the statute are now referred to, without regard
to the discretionary powers of the Banking Board to waive any or all of
them (supra p. 109).

117

118

SECURITY ANALYSIS

must be the same— i.e ., the ability of the company to meet all
its obligations. But this distinction would be equally applicable
to a second-mortgage issue and hence is not concerned with
debentures as such. We have already discussed the practicalities
of selecting as between senior and junior liens (pages 84-88) and
shall refer to this point again when we consider interest coverage.

Income Bonds in Weaker Position than Debentures.—While
the New York statute is too severe in its categorical exclusion
of all unsecured public-utility issues, its acceptance of railroad
income issues on the same basis as railroad debentures is fully as
objectionable for the opposite reason. The provisions of income
bonds vary greatly among the different issues, the basic distinc¬
tion being between those on which interest must be paid if
earned and those over which the directors have a greater or
lesser measure of discretion. Generally speaking, income bonds
are allied more closely to preferred stocks than to ordinary fixed
obligations. We shall consider them, accordingly, in our
chapter on preferred stocks, in which we shall set forth the need
for especial caution and strictness in the selection of this type
of security for straight investment.

Standards of Safety Should Not Be Relaxed Because of Early
Maturity.—Investors are inclined to attach considerable impor¬
tance to the maturity date of an issue, because of its bearing on
whether it is a short- or long-term security. A short maturity,
carrying with it the right to repayment soon after purchase, is
considered an advantageous feature from the standpoint of safety.
Consequently, investors are prone to be less exacting in their
standards when purchasing notes or bonds due in a short time
(say, up to three years) than in their other bond selections.

In our opinion this distinction is unsound. A near maturity
means a problem of refinancing for the company as well as a
privilege of repayment for the investor. The bondholder cannot
count on the mere fact of maturity to assure this repayment.
The company must either have the cash available (which happens
relatively seldom) or else an earning power and financial position
which will permit it to raise new funds. Corporations frequently
sell short-term issues because their credit is too poor at the time
to permit of a long-term flotation at a reasonable rate. Such a
practice frequently results in trouble for the company, and
therefore for the investor, at maturity.

FIXED-VALUE INVESTMENTS

119

Examples: The Fisk Rubber Company sold $10,000,000 of
five-year 5%s in 1926. In 1929 they sold at 96 because of their
near maturity, although the company’s earnings exhibit was
unsatisfactory. But payment of principal was defaulted at
maturity in 1931; the company went into receivership; and the
price of the notes fell to 10% in that year.

In 1929 the New York, Chicago and St. Louis Railway (Nickel
Plate) sold $20,000,000 of three-year 6% notes. They have
been repeatedly extended but only with great difficulty and
upon threat of insolvency if the Loaders refused to extend.
(In 1936 they sold as low as 26%.)

A recent example of apparently unwarranted partiality
accorded by the bond market to an issue of near maturity is
supplied by Pennsylvania-Dixie Cement Company First 6s,
due September 1941, which in early 1939 sold above par. This
issue had barely covered interest charges (on a reduced deprecia¬
tion basis) in 1937 and 1938, and had reported deficits in the six
preceding years. Net current assets were less than the out¬
standing bonds. It was possible, of course, that conditions in
1941 might permit the repayment of this security; but those who
bought it at a full price in 1939 were undoubtedly taking an
unnecessary risk of severe shrinkage of principal value.

Distinctions between Short and Long Maturities of the Same
Issue. —There have been quite a number of cases in which
investors have been willing to pay much higher prices for a short¬
term issue than for an equally secured long-term issue of the
same company. In nearly every case this has proved a mistake—
because either (1) the company’s credit improved, in which
case the distant maturity had a much greater rise in price, or
else (2) the company was unable to pay off the short term issue
at maturity.

Examples of (1):

Low Price 1932

Lehigh Valley Coal Company First Refunding 5s, due

1934 . 96H

Lehigh Valley Coal Company First Refunding 5s, due
1944 . 35

The company was able to pay off the 1934 issue at maturity,
but in the meantime the 5s of 1944 had advanced to 91. See also
example under (2) below.

120

SECURITY ANALYSIS

Low Price 1932

U. S. Rubber Company Secured 6>^s, due 1933. 94

U. S. Rubber Company Secured 6Ms, due 1935. 43

The 1933 issue was paid at maturity, but so was the 1935 issue,
which of course proved by far the better purchase.

Examples of (2):

High Price 1938

Lehigh Valley Coal Company First Refunding 5s, due

1944. 99 %

Lehigh Valley Coal Company First Refunding 5s, due
1954. 45

Interest was defaulted in January 1939, and the price of the
1944 issue collapsed to 36, versus 20 for the 1954 maturity.

Low Price 1932

Pressed Steel Car Debenture 5s, due 1933. 82

Pressed Steel Car Debenture 5s, due 1943. ... \. 40

Both defaulted on Jan. 1, 1933, and were ultimately treated
alike in the reorganization.

High Price 1934

Standard Gas and Electric Debenture 6s, due 1935. 94

Standard Gas and Electric Debenture 6s, due 1951. 60

The company failed to meet the 1935 maturity. In the ensu¬
ing reorganization the various debenture issues were treated
practically alike, and in 1939 they all sold at the same price.

Because of the foregoing discussion and examples we advise
against the drawing of distinctions between long- and short-term
issues such as result in any relaxation of standards of safety in
the selection of issues of the latter type. 1

1 In an exceptional case a short-term issue may be bought at an investment
price, even though the earnings exhibit is inadequate, provided the working
capital position is so strong as to assure payment without difficulty. Such
an investment would correspond to a loan made by a commercial bank.
Example: This would apply to Central Steel Company First 8s, assumed by
Republic Steel Corporation, due Nov. 1, 1941, and selling in November
1939 at 109 to yield 3.31 %. Note also that preference may properly be
given to short maturities at times as a matter of investment policy —but not
to the extent of relaxing the standards of safety.

FIXED-VALUE INVESTMENTS

121

RECORD OF INTEREST AND DIVIDEND PAYMENTS

Bonds purchased on an investment basis should have behind
them a sufficiently long record of successful operation and of
financial stability on the part of the issuer. New enterprises
and those recently emerged from financial difficulties are not
entitled to the high credit rating essential to justify a fixed-value
investment. 1 A similar disqualification would logically apply to
states or municipalities which have failed to meet their obliga¬
tions punctually at any time over a preceding period of years.

Provisions of New York Statute.—The New York statute
recognizes this criterion and gives it concrete expression as
follows: Bonds of states other than New York are eligible if the
state has not defaulted on interest or principal payments during
the previous ten years. For municipalities outside New York
State, the period is twenty-five years; for railroads, six years; for
gas, electric, and telephone companies, eight years .

With respect to bonds of corporations, however, the require¬
ments as to earnings coverage —to be discussed under the next
heading—should adequately take care of the question of past
record. The time covered by the earnings requirement is only a
little shorter than the periods above suggested, and hence it
would seem an unnecessary complication to exact a past-solvency
test in addition to an earnings test.

Civil obligations, on the other hand, are not sold on the basis of
an earnings record. Consequently the investor is compelled to
attach primary importance to a satisfactory history of punctual
payment. The requirement on this point set forth in the New
York statute would no doubt appear reasonable to the average
investor.

We cannot recommend such a rule of investment, however,
without considering the results that would follow from its gen¬
eral adoption. If all purchases of municipal bonds required a
clean record for 25 years, how could any township float a bond
issue during the first quarter-cenhory of its existence? And
similarly, if a state or city has been driven into default, how

1 This statement might not apply in those cases in which the financial
difficulties were due to an excessive debt burden which the reorganization
reduces to a figure that would have been amply taken care of by the previous
earnings.

122

SECURITY ANALYSIS

will it finance itself during the 10 or 25 years, respectively,
needed to restore its obligations to the eligible list? In the
case of corporations, such financing might be accomplished on
a speculative basis, through the sale of stock, or convertible
bonds, or even bonds at a large discount. But such methods
are not open to municipalities. The difficulty is met in actual
practice by raising the coupon rate on the obligations of states
or municipalities with inferior credit. For example, a city
emerging from financial embarrassment might be able to attract
new funds by offering a 5% coupon rate in contrast with 2%
paid by New York State. 1 But this solution of the problem
runs counter to the principle, previously developed, that a
high coupon rate is not adequate compensation for the assump¬
tion of substantial risk of principal. In other words, it would
be a mistake to buy a municipal obligation for its high yield,
if it is recognized as inferior in grade and subject to more than
a nominal possibility of default.

A Dilemma and a Suggested Solution.—We arc faced there¬
fore by a dilemma, since the theoretically correct attitude of
the bond buyer would render impossible the necessary financing
of many municipalities. Viewing the matter realistically, it
may be dismissed with the observation that there will always be
enough undiscriminating investors on hand to absorb the bonds
of any town or village which offers a seemingly attractive rate.
Consequently the logical and careful bond buyer can avoid such
issues without fatal results to borrowers having second-rate
credit.

This disposition of the dilemma is too cynical to be entirely
satisfactory. The ideal solution would probably lie in setting
up some especially stringent quantitative tests to compensate
for the failure by a municipality to meet the twenty-five year
requirement of punctual payment. If a city has fallen into
financial difficulties, it must rehabilitate itself by reducing its
expenditures, or by raising its tax rate and other revenue, or
possibly by a compulsory scaling down of its debt, corresponding
to a corporate reorganization. By such means the town may
place its finances on ari entirely new and sound basis entitling

1 Note that in November 1939 City of Detroit obligations due 1954 (which
had been in default in 1933) sold at a 3.70% yield basis, as against a return
of about 2 % on similar bonds of smaller municipalities with a good record.

FIXED-VALUE INVESTMENTS

123

it to a satisfactory credit rating in spite of its previous default.
But the prudent investor will accord such a credit rating only
after a careful study of the financial exhibit, including such
items as the relation of expenditures and total debt, on the
one hand, to population, property values and revenues, on the
other. The bond buyer should expect to obtain a higher than
standard yield on municipal obligations of this character, in
repayment not for the assumption of special risky but for the effort
required to satisfy himself of the soundness of the issue .

A similar attitude should be taken towards newly organized
civil bodies, where only a short record of debt service is available. 1

The Dividend Record.—The statutes governing legal invest¬
ments have traditionally laid great stress upon a satisfactory
record of dividend payments by the issuing enterprise. In most
states a bond is eligible only if the company has paid regular
dividends in certain minimum amounts for at least five years.
This requirement is evidently based on the theory that since
corporations exist in order to pay dividends, only those which
do in fact pay dividends may be said to be really successful and
therefore suitable for bond investment.

Dividend Record Not Conclusive Evidence of Financial Strength.
It may not be denied that dividend-paying concerns as a
class are more prosperous than non-dividend payers. But
this fact would not in itself justify the summary condemnation
of all the bonds of non-dividend-paying enterprises. An exceed¬
ingly strong argument against such a rule lies in the fact that the
payment of dividends is only an indication of financial strength;
and not only does it fail to afford any direct advantage to the

1 The technique of analysis of state or municipal finances is elaborate and
it does not lend itselt to dependable short cuts. An adequate treatment of
the subject would lie outside the purview of this book or the competence
of the authors. We refer the reader to treatments of the subject in standard
works on investment such as Hastings Lyon, Investment , pp. 56-179, New
York, 1926; Ralph E. Badger and Harry G. Guthmann, Investment: Princi¬
ples and Practices , pp. 735-780, rev. ed., New York, 1936; and to Proceedings
of the Conference on Bond Portfolios 1939 of the New York State Bankers
Association, pp. 136-158, New York, 1939; Investment Standards and
Procedure , which is Commercial Bank Management Booklet No. 19, issued by
the Bank Management Commission of the American Bankers Association,
New York, 1937; A. M. Hillkouse, Municipal Bonds: A Century of Experi¬
ence, New York, 1936.

124

SECURITY ANALYSIS

bondholder, but it may often be injurious to his interests by
reducing the corporation’s resources. In actual practice the
dividend provisions of the statutes governing legal investments
have at times had consequences directly opposite to those
intended. Railroad companies in a weak financial position have
improvidently continued dividend payments for the particular
purpose of maintaining their bonds on the eligible list, so that
the very practice supposed to indicate strength behind the bond
has in reality undermined its safety. 1

The Role of the Dividend Record in Bond Investment .—The
evidence given by the balance sheet and income account must
be regarded as a more dependable clue to the soundness of an
enterprise than is the record of dividend payments. It seems
best therefore to dispense with all hard and fast rules on the
latter point in determining the suitability of bond issues for
straight investment. But the failure of a company to pay divi¬
dends when the earnings appear satisfactory should properly
cause an intending bond buyer to scrutinize the situation with
more than usual care, in order to discover whether the policy
of the directors is due to weak elements in the picture not yet
reflected in the income account. We might also point out inci¬
dentally that the bonds of dividend-paying companies possess a
certain mechanical advantage in that their owners may receive
a definite and perhaps timely warning of impending trouble by
the later passing of the dividend; and being thus placed on their
guard, they may be able to protect themselves against serious
loss. Bonds of non-dividend-paying concerns are at a certain
disadvantage in this respect, but in our opinion this may be
adequately offset by the exercise of somewhat greater caution on
the part of the investor.

The New York statute is somewhat more progressive than
those of other states in its treatment of the dividend question.

1 Cf. the testimony of the chairman of the New Haven in December 1936,
in the Interstate Commerce Commission's investigation of that road,
admitting that dividends were paid in 1931 to keep its bonds “legal” and
listing other roads that paid unearned dividends presumably for the same
reason (see New York Times of Dec. 3, 1936). For a much earlier example,
see Dewing's discussion of the payment of unearned dividends by Boston
and Maine Railroad in 1911-1913, to keep its bonds legal (Financial Policy
of Corporations , 3d rev. ed., p. 609n). Also see our reference to the Wabash-
Ann Arbor in 1930, p. 441n.

FIXED-VALUE INVESTMENTS

125

Railroads are required alternatively either to have paid divi¬
dends of a certain amount in five out of the last six years, or
failing this, to meet more stringent requirements as to coverage
of fixed charges. Public-utility companies are required either
to have paid certain dividends in each of the five preceding years,
or else to have earned an amount equal thereto. This provision
falls into the error of the other statutes by possibly impelling
payment of unearned dividends. The progressive idea appears
in the converse side of the provision, which waives payment
of dividends so long as they are earned.

RELATION OF EARNINGS TO INTEREST REQUIREMENTS

The present-day investor is accustomed to regard the ratio
of earnings to interest charges as the most important specific
test of safety. It is to be expected therefore that any detailed
legislation governing the selection of bond investments would
be sure to include minimum requirements in respect to this
cardinal factor. Nevertheless the majority of the statutes
cover this point in only a fragmentary and inadequate manner.
The legislatures have relied to a considerable extent on their
requirements as to the company's dividend record to assure a
satisfactory earning power. 1 As we have just pointed out, this
criterion is open to serious objection. The superiority of the
New York statute is manifest chiefly in two provisions: first, its
recognition of the prime importance of an adequate earnings
record; and secondly, its consistent treatment of a company's
total fixed charges as an indivisible unit.

Requirements of the New York Law.—The requirements of the
New York law with respect to earnings coverage may be sum¬
marized as follows:

In the case of railroad-mortgage bonds (or collateral-trust
bonds equivalent thereto) and railroad-equipment obligations,
the company must have earned its fixed charges 1J^ times in
five out of the six years immediately preceding, and also in the
latest year. If dividends have not been paid as stipulated, then
the period is set at nine out of the ten preceding years.

1 Vermont, for example, permits investment in bonds of New England
railroads without any earnings test; in the case of other roads the fixed
charges must not exceed 20 % of the gross business. A record of continuous
dividend payments is required in both cases.

126

SECURITY ANALYSIS

In the case of other kinds of railroad bonds, c.g., debentures,
income obligations, etc., the fixed charges (plus interest on
income bonds, if any) must be earned twice in both the latest
year and in five out of the six preceding years. In this category,
the requirement as to dividend payments is apparently absolute,
and no substitute therefor is admitted.

In the case of gas, electric, and telephone bonds, the average
earnings for the past five years must have equalled twice the
average total-interest charges, and the same coverage must have
been shown in the latest year.

Three Phases of the Earnings Coverage: 1. Method of Compu¬
tation.—In analyzing these statutory provisions, three elements
deserve consideration. The first is the method of computing
the earnings coverage; the second is the amount of coverage
required; and the third is the period required for the test.

The Prior-deductions Method. —Various methods arc in com¬
mon use for computing and stating the relation of earnings to
interest charges. One of these (which may be called the Prior-
deductions Method) is thoroughly objectionable. Nevertheless,
prior to 1933 it was followed by the majority of issuing houses in
their circulars offering junior bonds for sale, because it makes for a
deceptively strong exhibit. The procedure consists of first
deducting the prior charges from the earnings and then calcu¬
lating the number of times the junior requirements are covered
by the balance. The following illustration will show both the
method itself and its inherent absurdity:

Company A has $10,000,000 of first-mortgage, 5 % bonds and $5,000,000
of debenture 6 % bonds.

Its average earnings are $1,400,000.

Deduct interest on first 5s 500,000 earned 2.8 times

Balance for debenture 6s $ 900,000

Interest on debenture 6s $ 300,000 earned 3 times

A circular offering the 6% debenture issue was likely to
state that “as shown above” the interest charges are covered
three times. It should be noted, however, that the interest on
the first 6s is covered only 2.8 times. The implication of these
figures would be that the junior issue is better protected than
the senior issue, which is clearly absurd. The fact is that the
results shown for junior bonds by this prior-deductions method
are completely valueless and misleading. One of the favorable

FIXED-VALUE INVESTMENTS

127

results of the Securities Act of 1933 has been the abandonment
of this indefensible method of stating interest coverage in new
bond offerings. This change has been due, apparently, not to
any specific prohibition by the statute or the S.E.C. regulations
but rather to the desire to avoid risking penalties for deceit.

Some Canadian bond offering circulars still use the prior-
deductions method. Example: Famous Players Canadian Cor¬
poration, Ltd., First and Collateral Trust Bonds, Series A, offered
about June 1936.

The Cumulative-deductions Method. —The second procedure
may be called the Cumulative-deductions Method. Under
this method, interest on a junior bond is always considered in
conjunction with prior and equivalent charges. In the example
given, the interest on the debenture 6s would be computed as
earned 1% times, found by dividing the combined charges of
both issues, namely $800,000, into the available earnings of
$1,400,000. The first-mortgage interest, however, would be
said to be earned 2.8 times, since bond interest junior to the
issue analyzed is left out of consideration in this method. The
majority of investors would regard this point of view as entirely
sound, and the procedure has been specifically prescribed by a
number of states in their enactments governing the eligibility
of bonds for savings-bank investment. 1

The Total-deductions or 11 Over-all” Method. —In a previous
chapter, however, we have emphasized the primary importance
of a company’s ability to meet all its fixed obligations, because
insolvency resulting from default on a junior lien invariably
reacts to the disadvantage of the prior-mortgage bondholders.
An investor can be sure of his position only if the total-interest
charges are well covered. Consequently, the conservative and
therefore advisable way of calculating interest coverage should
always be by the “total-deductions method”; i.e. } the controlling
figure should be the number of times that all fixed charges are

1 See, for example, Maine } Sec. 27, Chap. 57 of Revised Statutes, as
amended by Chap. 222 of Public Laws 1931, subsections VI, VII and VIII,
dealing with obligations of steam railroads, public utilities and telephone
companies. Similar provisions are to be found in the Vermont statute
relative to public-utility bonds. New Hampshire permits the cumulative-
deductions method for railroad and public-service company bonds; but,
rather strangely, it requires the total-deductions method in the case of the
bonds of telephone and telegraph companies.

128

SECURITY ANALYSIS

covered. This would mean that the same earnings ratio would be
used in analyzing all the fixed interest bonds of any company ,
whether they are senior or junior liens. In the example above
given, the ratio would be 1%, as applied to either the first 5s or
the debenture 6s. In bond circulars and annual reports this
method is now commonly referred to as the “over-all basis” for
computing interest coverage. 1

It is important to bear in mind that fixed charges exclude
income-bond interest which is a contingent charge. The words
“interest charges” and “bonded debt” are also used, for con¬
venience, to refer only to fixed-interest bonds unless the context
indicates otherwise.

There is no reason, of course, why the coverage for a senior
bond should not be computed by the cumulative-deductions
method also, and if this coverage is very large it may properly
be regarded as an added argument in favor of the issue. But our
recommendation is that in applying any minimum requirement
designed to test the company's strength, the total fixed charges
should always be taken into account. The New York statute
holds consistently to this very stand, and in our opinion it
deserves to be approved and followed.

2. Minimum Requirements for Earnings Coverage. —The
preference accorded by the New York statute to railroad bonds
over public-utility issues is no longer justified, and the more
recent record of both groups suggests that their relative positions
should be reversed. It is necessary, also, to add a minimum
figure for industrial bonds, which should clearly be set higher
than for either utilities or rails. Taking these factors into
account, we should recommend the following minimum require¬
ments for the coverage of total fixed charges:

Public utilities. 1 % times

Railroads. 2 times

Industrials. 3 times

1 The phrases: “earnings ratio,” “times interest earned,” and “earnings
coverage,” all have the same significance. The statement that “interest
is covered 1 % times” is more readily understood than the equivalent expres¬
sion, sometimes used, that “the factor of safety is 75%,” and we should
advise the consistent use of the former type of expression. Some authorities
(e. 0 ., Moody's “ Manual of Investments ” prior to 1930) have used the expres¬
sion “margin of safety” to mean the ratio of the balance after interest to the

FIXED-VALUE INVESTMENTS

129

3. The Period Comprised by the Earnings Test. —Our sum¬
mary of the New York provisions regarding earnings coverage
pointed out that the five-year average is used in the case of
utility issues. For railroad - bonds, however, the stipulated
minimum margin must be shown in five separate years out of
the latest six. In all instances, the minimum must be met in
the year immediately preceding the date of investment.

Requirements such as the last two are easy to promulgate,
but they are poorly suited to the realities of bond investment
in an economic world subject to recurring years of serious depres¬
sion. If it should be characteristic of business in general to
experience eight prosperous or average years followed by two
unprofitable ones, the effect of these rules would be to encourage
investment in bonds (at high prices) during good times, and to
impel their sale (at low prices) during depressions. 1

In our view, the only practical rigid application of a minimum-
earnings standard must be to the average results over a period
of time. A five-year average, as prescribed by the statute
in the case of public-utility bonds, would seem too short under
many circumstances, and we should suggest a seven-year period
as a more suitable normal standard. But this might be shortened
somewhat to exclude clearly abnormal years. (For example,
the six-year period 1934-1939 would probably provide a fairer
test period than the seven-year period 1933-1939.)

If the test had been made, say, in 1934 or 1935, it would have
been better to use a ten- or even twelve-year period to avoid
giving undue weight to years of severe depression. Practical
considerations suggest also that averaging-in the large deficits
experienced by some industrial companies during 1931-1933
might produce an earnings-coverage figure too low to be fairly
representative of the current situation, even though a long¬
term average were taken. This difficulty may be solved,

earnings available for interest. Example: If interest is covered times
the margin of safety becomes % + \% = 42^ %.

1 The impracticability of these provisions of the New York statute is best
evidenced by the fact that annual amendments were deemed necessary
between 1931 and 1937 inclusive, their effect being to exclude the results
of 1931 through 1936 from the earnings test. This “moratorium” termi¬
nated in April 1938, at which time over $3,000,000,000 par value of railroad
bonds were removed from the eligible list. A new moratorium retains
bonds of carriers that have earned interest charges once over in the last year
and in five out of the last six years.

130

SECURITY ANALYSIS

arbitrarily, by considering the earnings in deficit years as zero
instead of the actual negative figure.

Example:

Interest coverage of Fairbanks Morse Company Debenture

4s, due 1956, as of early 1938.

Interest charges, 1937. $ 232,000

Earned after interest and taxes, 1937. 2,148,000

1937 interest earned. 10.2 times

Total earnings after interest, 1928-30 and

1934-1937. 11,740,000

Total deficits after interest, 1931-1933. 8,873,000

Annual earnings after interest, 1928-37. 287,000

Indicated 10-year coverage for 1937 interest

charges. 2.2 times

Alternative basis for calculating the 10-year
coverage:

10-ycar average earnings after interest, count¬
ing 1931-1933 years as zero. $ 1,174,000

Revised 10-year coverage for 1937 interest
charges. 6 1 times

Stock-equity ratio. S3.42 of stock at market for each SI

of bonds at par

The second, or revised, average must be considered as a
more realistic reflection of the company’s earning power than the
straight ten-year average, which fails to meet our minimum
requirement. We trust, however, that from 1940 on it will be
possible to use seven-year averages, or longer, without having
to meet a similar problem.

Other Phases of the Earnings Record.—There are, of course, a
number of other aspects of the earnings picture to which the
investor would do well to pay attention. Among these are
the trend , the minimum figure, and the current figure. The
importance of each of these cannot be gainsaid, but they do not
lend themselves effectively to the application of hard and fast
rules. In this case, as in the matter of mortgage security
previously discussed, a distinction must be drawn between the
few factors which can successfully be embraced by definite
and universally applicable rules, and the many other factors
which resist such exact formulation but must nevertheless be
taken into account by the judgment of the investor.

Unfavorable Factors May Be Offset.—The practical method
of dealing with elements of the latter type may be illustrated

FIXED-VALUE INVESTMENTS

131

in this matter of the earning exhibit. The investor must demand
an average at least equal to the minimum standard. In addition,
he will be attracted by: (a) a rising trend of profits; ( b) an
especially good current showing; and (c) a satisfactory margin
over interest charges in every year during the period studied.
If a bond is deficient in any one of these three aspects, the result
should not necessarily be to condemn the issue but rather to
exact an average earnings coverage well in excess of the minimum
and to require closer attention to the general or qualitative
elements in the situation. If the trend has been unfavorable, or
the latest figure alone has been decidedly poor, the investor
should certainly not accept the bond unless the average earnings
have been substantially above the minimum requirement— and
unless also he has reasonable grounds for believing that the down¬
ward trend or the current slump is not likely to continue indefinitely .
Needless to say, the amount by which the average must be
advanced in order to offset an unfavorable trend or current
exhibit is a matter within the discretion of the investor to deter¬
mine, and cannot be developed into any set of mathematical
formulas.

The Relation of the Coupon Rate to the Earnings Coverage.—

The theory of earnings coverage is complicated by the arith¬
metical fact that this coverage varies inversely with the rate of
interest. Given the same earnings, interest on a 3% bond issue
would be earned twice as many times as it would be if the rate
were 6%. Consider the following comparison:

Utility Company A

Utility Company B

Earnings for interest.

$000,000

$600,000

Interest charges.

(3% on $10,000,000)

(5>*% on $10,000,000)

300,000

550,000

Times interest earned....

2.00

1.09

The difference in coupon rates alone makes Company A
pass our earnings coverage test, whereas Company B barely
earns its interest. This point may well raise several questions,
viz.: (1) Can a bond be considered “safe” merely because it
carries a low coupon rate? (2) What would be the effect on this
safety of a rise in the general rate of interest? (3) Are the
bonds of Company A a sounder purchase for investment than

132

SECURITY ANALYSIS

those of Company B? Let us attempt to answer these questions
briefly in their order.

1. Effect of Coupon Rate on Safety. —Safety, in the technical
sense of assurance of continued payment of interest, can certainly
be created or destroyed by varying the coupon rate. It is not
feasible to think of a 53^ % bond as being safe as to 3 % interest
and unsafe as to the additional 2J^%. Safety of interest is an
indivisible concept and must apply to the entire interest charge,
the reason being that inability to pay part of the contractual
interest—or even junior interest—will result in financial diffi¬
culties. These in turn mean the destruction, at least tem¬
porarily, of the investment status.

Safety in the sense of maintenance of principal value can also
be “created” by a low rate of interest, provided this rate is
considered to be permanent—i.e., lasting either through maturity
or for a great many years in the future. If the 3% rate is
permanent, the earnings of $600,000 should enable Company A
to refund its bonds at maturity, and they should also maintain
the market price of the bonds not far from par.

Allowance must be made for the fact that the rate of interest
tends to vary inversely with the ability of the company to pay it.
A strong company borrows at a low rate, although it could
afford to pay more than could a weak company. This means
that “good credit” itself produces “better credit” through its
own saving in interest charges, whereas the opposite is equally
true. Although this may seem paradoxical and unfair, it must
be accepted as a fact in security analysis.

2. Effect of a Rise in Interest Rates on Safety .—A general rise
in interest rates would not affect the ability of a company to
meet its interest charges during the life of its low-rate bond
issue. But if they mature in a short time, it will be faced with
the problem of refunding at a higher rate, to effect which its
earnings must show an adequate margin above this higher rate.
On the other hand, if the maturity is distant the market price of
this and other bonds will decline substantially should the general
rate of interest experience a considerable rise. (Note that the
Dow-Jones Index of bond prices declined about 30% between
1917 and 1920, reflecting a rise in interest rates.)

It follows, therefore, that safety of principal, in the sense of
maintenance of market value, is certain to be affected adversely

FIXED-VALUE INVESTMENTS

133

in the case of long-term bonds by a sharp rise in the rate of
interest. 1 Safety of principal of short-term debt may be affected
adversely by such a rise in interest rates if the earnings coverage
does not exceed our minimum by a comfortable margin.

The practical conclusion must be that if the investor considers
a rise in interest rates probable, he should not buy long-term
low-coupon bonds, no matter how strong the company; and he
should buy short-term issues only if earnings would cover a
higher coupon rate with an adequate margin. If, however, he is
convinced that the low interest rates are here to stay, he may
accept them in the same way as the higher rates were formerly
accepted. If he is undecided as to the future of interest rates,
the best policy might seem to be to confine purchases to bonds of
fairly short maturity (say not longer than ten years) and also to
increase his earnings coverage requirement to offset the low
coupon rate.

3. Relative Attractiveness of the Two Bonds .—Our third question
relates to the comparative attractiveness of the 3% bonds of
Company A and the 5)^% bonds of Company B . In strict
logic the % bond must certainly be more desirable than the
3% bond, since the 5J^% bondholder could always place his
claim to the extra 2}^% on a contingent basis and thus make his
company’s margin above fixed charges the same as Company A’s.
But in practice such a reduction of fixed interest is likely to be
made only after the issuer has fallen into financial difficulties,
which in turn would cause a substantial decline in the market
price of the issue. Hence, as a practical matter, it is possible
that the holder of the 3 % bond may fare better than the owner
of the % bond.

However, the anomaly evident in our example should carry a
warning to the investor not to pay about par for a 3% bond on
the showing of Company A unless he is absolutely convinced of
the permanence of very low interest rates. (It will also indicate
that there are certain speculative opportunities inherent in a
bond of the Company B type if it is selling at a very low price
because of the small margin above its high interest charges—
especially if continuance of low interest rates is expected.)

1 An exception would be high-coupon bonds whose price had been held
down by a callable feature.

CHAPTER X

SPECIFIC STANDARDS FOR BOND INVESTMENT

( Continued)

THE RELATION OF THE VALUE OF THE PROPERTY
TO THE FUNDED DEBT

In our earlier discussion (Chap. VI) we pointed out that
the soundness of the typical bond investment depends upon the
ability of the obligor corporation to take care of its debts,
rather than upon the value of the property on which the bonds
have a lien. This broad principle naturally leads directly away
from the establishment of any general tests of bond safety based
upon the value of the mortgaged assets, where this value is
considered apart from the success or failure of the enterprise
itself.

Stating the matter differently, we do not believe that in the
case of the ordinary corporation bond—whether railroad, utility,
or industrial—it would be advantageous to stipulate any mini¬
mum relationship between the value of the physical property
pledged (taken at either original or reproduction cost) and the
amount of the debt. In this respect we are in disagreement
with statutory provisions in many states (including New York)
which reflect the traditional emphasis upon property values.
The New York law, for example, will not admit as eligible a
gas, electric, or telephone bond, unless it is secured by property
having a value 66%% in excess of the bond issue. This value
is presumably book value, which either may be the original
dollar cost less depreciation or may be some more or less artificial
value set up as a result of transfer or reappraisal.

Special Types of Obligations: 1. Equipment Obligations. —It
is our view that the book value of public-utility properties—
and of railroads and the typical industrial plant as well—
is no guidance in determining the safety of the bond issues
secured thereon. There are, however, various special types of
obligations, the safety of which is in great measure dependent

134

FIXED-VALVE INVESTMENTS

135

upon the assets securing them, as distinguished from the going-
concern value of the enterprise as a whole. The most char¬
acteristic of these, perhaps, is the railroad-equipment trust
certificate, secured by title to locomotives, freight cars, or
passenger cars, and by the pledge of the lease under which the
railroad is using the equipment. The investment record of
these equipment obligations is very satisfactory, particularly
because until recently even the most serious financial difficulties
of the issuing road have very rarely prevented the prompt pay¬
ment of interest and principal. 1 The primary reason for these
good results is that the specific property pledged is removable and
usable by other carriers. Consequently it enjoys an independent
salable value, similar to automobiles, jewelry, and other chattels
on which personal loans are made. Even where there might be
great difficulty in actually selling the rolling stock to some other
railroad at a reasonable price, this mobility still gives the equip¬
ment obligation a great advantage over the mortgages on the
railroad itself. Both kinds of property are essential to the oper¬
ation of the line, but the railroad bondholder has no alternative
save to permit the receiver to operate his property, while the
holder of the equipment lien can at least threaten to take the
rolling stock away. It is the possession of this alternative which
in practice has proved of prime value to the owner of equipment
trusts because it has virtually compelled the holders even of the
first mortgages on the road itself to subordinate their claim to
his.

It follows that the holder of equipment-trust certificates
has two separate sources of protection, the one being the credit
and success of the borrowing railway, the other being the value
of the pledged rolling stock. If the latter value is sufficiently
in excess of the money loaned against it, he may be able to ignore
the first or credit factor entirely, in the same way as a pawn¬
broker ignores the financial status of the individual to whom he
lends money and is content to rely exclusively on the pledged
property.

The conditions under which equipment trusts are usually
created supply a substantial degree of protection to the pur¬
chaser. The legal forms arc designed to facilitate the enforce-

1 See Appendix Note 17, p. 739, for information on the investment record
of such issues.

136

SECURITY ANALYSIS

ment of the lienholder's rights in the event of nonpayment. In
practically all cases at least 20% of the cost of the equipment is
provided by the railway, and consequently the amount of the
equipment obligations is initially not more than 80% of the value
of the property pledged behind them. The principal is usually
repayable in 15 equal annual installments, beginning one year
from issuance, so that the amount of the debt is reduced more
rapidly than ordinary depreciation would require.

The protection accorded the equipment-trust holder by these
arrangements has been somewhat diminished in recent years,
due partly to the drop in commodity prices which has brought
reproduction (and therefore, salable) values far below original
cost, and also to the reduced demand for equipment, whether
new or used, because of the smaller traffic handled. Since
1930 certain railroads in receivership (e.g., Seaboard Air Line and
Wabash) have required holders of maturing equipment obli¬
gations to extend their maturities for a short period or to exchange
them for trustee's or receiver's certificates carrying a lower
coupon. In the unique case of one Florida East Coast Railway
issue (Series “D”) the receivers permitted the equipment-trust
holders to take over and sell the pledged equipment, which
seemed to have been less valuable than that securing other
series. In this instance the holders realized only 43 cents on the
dollar from the sale and have a deficiency judgment (of doubtful
value) against the road for the balance. These maneuvers and
losses suggest that the claim of “almost absolute safety" fre¬
quently made in behalf of equipment issues will have to be
moderated; but it cannot be denied that this form of investment
enjoys a positive and substantial advantage through the realiza¬
bility of th( pledged assets. 1 (This conclusion may be supported
by a concrete reference to the sale in November 1939 of Chicago
and North Western new Equipment Trust 23^s, due 1940-1949,
at prices to yield only from 0.45 to 2.35%, despite the fact that
all the mortgage issues of that road were then in default.)

2 . Collateral-trust Bonds.—Collateral-trust bonds are obli¬
gations secured by the pledge of stocks or other bonds. In the
typical case, the collateral consists of bonds of the obligor
company itself, or of the bonds or stocks of subsidiary corpo-

1 See Appendix Note 18, p. 742, for comment and supporting data.

FIXED-VALUE INVESTMENTS

137

rations. Consequently the realizable value of the collateral is
usually dependent in great measure on the success of the enter¬
prise as a whole. But in the case of the collateral-trust issues of
investment companies, a development of recent years, the
holder may be said to have a primary interest in the market
value of the pledged securities, so that it is quite possible that
by virtue of the protective conditions in the indenture, he may
be completely taken care of under conditions which mean virtual
extinction for the stockholders. This type of collateral-trust
bond may therefore be ranked with equipment-trust obligations
as exceptions to our general rule that the bond buyer must place
his chief reliance on the success of the enterprise and not on the
property specifically pledged.

Going behind the form to the substance, we may point out
that this characteristic is essentially true also of investment-
trust debenture obligations. For it makes little practical differ¬
ence whether the portfolio is physically pledged with a trustee,
as under a collateral-trust indenture, or whether it is held by
the corporation subject to the claim of the debenture bond¬
holders. In the usual case the debentures are protected by
adequate provisions against increasing the debt, and frequently
also by a covenant requiring the market price of the company’s
assets to be maintained at a stated percentage above the face
amount of the bonds.

Example: The Reliance Management Corporation Debenture
5s, due 1954, arc an instance of the working of these protective
provisions. The enterprise as a whole was highly unsuccessful,
as is shown vividly by a decline in the price of the stock from
69 in 1929 to 1 in 1933. In the case of the ordinary bond issue,
such a collapse in the stock value would have meant almost
certain default and large loss of principal. But here the fact
that the assets could be readily turned into cash gave significance
to the protective covenants behind the debentures. It made
possible and compelled the repurchase by the company of more
than three-quarters of the issue, and it even forced the stock¬
holders to contribute additional capital to make good a deficiency
of assets below the indenture requirements. This resulted in
the bonds selling as high as 88 in 1932 when the stock sold for
only The balance of the issue was called at 104J^[ in

February 1937.

138

SECURITY ANALYSIS

In Chap. XVIII, devoted to protective covenants, we shall
refer to the history of a collateral-trust bond issue of an invest¬
ment company (Financial Investing Company), and we shall
point out that the intrinsic strength of such obligations is often
impaired—unnecessarily, in our opinion—by hesitation in assert¬
ing the bondholders’ rights.

3. Real Estate Bonds.—Of much greater importance than
either of the two types of securities just discussed is the large
field of real estate mortgages and real estate mortgage bonds.
The latter represent participations of convenient size in large
individual mortgages. There is no doubt that in the case of
such obligations the value of the pledged land and buildings is
of paramount importance. The ordinary real estate loan made
by an experienced investor is based chiefly upon his conclusions
as to the fair value of the property offered as security. It
seems to us, however, that in a broad sense the values behind
real estate mortgages arc going-concern values; i.e ., they are
derived fundamentally from the earning power of the property,
either actual or presumptive. In other words, the value of the
pledged asset is not something distinct from the success of the
enterprise (as is possibly the case with a railroad-equipment
trust certificate), but is rather identical therewith.

This point may be made clearer by a reference to the most
typical form of real estate loan, a first mortgage on a single-
family dwelling house. Under ordinary conditions a home
costing $10,000 would have a rental value (or an equivalent value
to an owner-tenant) of some $1,200 per year, and would yield a
net income of about $800 after taxes and other expenses. A 5%
first-mortgage loan on the savings-bank basis, i.e., 60% of value,
or $6,000, would therefore be protected by a normal earning
power of over twice the interest requirements. Stated differ¬
ently, the rental value could suffer a reduction of over one-third
before the ability to meet interest charges would be impaired.
Hence the mortgagee reasons that regardless of the ability of the
then owner of the house to pay the carrying charges, he could
always find a tenant or a new purchaser who would rent or buy
the property on a basis at least sufficient to cover his 60% loan.
(By way of contrast, it may be pointed out that a typical indus¬
trial plant , costing $1,000,000 and bonded for $600,000, could

FIX ED-VALUE INVESTMENTS

139

not be expected to sell or rent for enough to cover the 5%
mortgage if the issuing company went into bankruptcy.)

Property Values and Earning Power Closely Related .— This
illustration shows that under normal conditions obtaining in
the field of dwellings, offices, and stores, the property values and
the rental values go hand in hand. In this sense it is largely
immaterial whether the lender views mortgaged property of this
kind as something with salable value or as something with an
earning power, the equivalent of a going concern. To some
extent this is true also of vacant lots and unoccupied houses or
stores, since the market value of these is closely related to the
expected rental when improved or let. (It is emphatically not
true, however, of buildings erected for a special purpose, such as
factories, etc.)

Misleading Character of Appraisals. —The foregoing discussion
is important in its bearing on the correct attitude that the
intending investor in real estate bonds should take towards the
property values asserted to exist behind the issues submitted to
him. During the great and disastrous development of the real
estate mortgage-bond business between 1923 and 1929, the only
datum customarily presented to support the usual bond offering—
aside from an estimate of future earnings—was a statement of
the appraised value of the property, which almost invariably
amounted to some 66%% in excess of the mortgage issue. If
these appraisals had corresponded to the market values which
experienced buyers of or lenders on real estate would place upon
the properties, they would have been of real utility in the selection
of sound real estate bonds. But unfortunately they were purely
artificial valuations, to which the appraisers were willing to
attach their names for a fee, and whose only function was to
deceive the investor as to the protection which he was receiving.

The method followed by these appraisals was the capital¬
ization on a liberal basis of the rental expected to be returned
by the property. By this means, a typical building which cost
$1,000,000, including liberal financing charges, w'ould immedi¬
ately be given an “appraised value” of $1,500,000. Hence a
bond issue could be floated for almost the entire cost of the
venture so that the builders or promoters retained the equity
(t.e. f the ownership) of the building, without a cent’s investment,

140

SECURITY ANALYSIS

and in many cases with a goodly cash profit to boot. 1 This
whole scheme of real estate financing was honeycombed with
the most glaring weaknesses, and it is sad commentary on the
lack of principle, penetration, and ordinary common sense on
the part of all parties concerned that it was permitted to reach
such gigantic proportions before the inevitable collapse. 2

Abnormal Rentals Used as Basis of Valuation. —It was indeed
true that the scale of rentals prevalent in 1928-1929 would
yield an abundantly high rate of income on the cost of a new
real estate venture. But this condition could not properly
be interpreted as making a new building immediately worth
50% in excess of its actual cost. For this high income return
was certain to be only temporary, since it could not fail to
stimulate more and more building, until an oversupply of space
caused a collapse in the scale of rentals. This overbuilding
was the more inevitable because it was possible to carry it on
without risk on the part of the owner, who raised all the money
needed from the public.

Debt Based on Excessive Construction Costs. —A collateral
result of this overbuilding was an increase in the cost of construc¬
tion to abnormally high levels. Hence even an apparently
conservative loan made in 1928 or 1929, in an amount not
exceeding two-thirds of actual cost f did not enjoy a proper
degree of protection, because there was the evident danger
(subsequently realized) that a sharp drop in construction costs
would reduce fundamental values to a figure below the amount of
the loan.

Weakness of Specialized Buildings. —A third general weakness
of real estate-bond investment lay in the entire lack of discrimi¬
nation as between various types of building projects. The
typical or standard real estate loan was formerly made on a
home, and its peculiar virtue lay in the fact that there was an
indefinitely large number of prospective purchasers or tenants

1 The 419-4th Avenue Corporation (Bowkcr Building) floated a $1,230,000
bond issue in 1927 with a paid-in capital stock of only $75,000. (By the
familiar process, the land and building which cost about $1,300,000 were
appraised at $1,897,788.) Default and receivership in 1931-1932 were
inevitable.

2 See Appendix Note 19, p. 742, for report of Real Estate Securities Com¬
mittee of the Investment Bankers Association of America commenting on
defaults in this field.

FIXED-VALUE INVESTMENTS

141

to draw upon, so that it could always be disposed of at some
moderate concession from the current scale of values. A fairly
similar situation is normally presented by the ordinary apart¬
ment house, or store, or office’ building. But when a structure
is built for some special purpose, such as a hotel, garage, club,
hospital, church, or factory, it loses this quality of rapid dis¬
posability, and its value becomes bound up with the success of the
particular enterprise for whose use it was originally intended.
Hence mortgage bonds on such structures are not actually real
estate bonds in the accepted sense, but rather loans extended to
a business; and consequently their safety must be judged by all
the stringent tests surrounding the purchase of an industrial
obligation.

This point was completely lost sight of in the rush of real
estate financing preceding the collapse in real estate values.
Bonds were floated to build hotels, garages, and even hospitals, on
very much the same basis as loans made on apartment houses.
In other words, an appraisal showing a “value” of one-half to
two-thirds in excess of the bond issue was considered almost
enough to establish the safety of the loan. It turned out,
however, that when such new ventures proved commercially
unsuccessful and were unable to pay their interest charges, the
“real estate” bondholders were in little better position than
the holders of a mortgage on an unprofitable railroad or mill
property. 1

Values Based on Initial Rentals Misleading .—Another weak¬
ness should be pointed out in connection with apartment-house
financing. The rental income used in determining the appraised
value was based on the rentals to be charged at the outset.
But apartment-house tenants are accustomed to pay a substantial
premium for space in a new building, and they consider a struc¬
ture old, or at least no longer especially modern and desirable,
after it has been standing a very few years. Consequently, under
normal conditions the rentals received in the first years are
substantially larger than those which can conservatively be
expected throughout the life of the bond issue.

Lack of Financial Information. —A defect related to those
discussed above, but of a different character, was the almost
universal failure to supply the bond buyer with operating and

1 See Appendix Note 20, p. 744, for example (Hudson Towers).

142

SECURITY ANALYSIS

financial data after his purchase. This drawback applies gener¬
ally to companies that sell bonds to the public but whose stock is
privately held—an arrangement characteristic of real estate
financing. As a result, not only were most bondholders unaware
of the poor showing of the venture until default had actually
taken place, but—more serious still—at that time they fre¬
quently found that large unpaid taxes had accrued against the
property while the owners were “milking” it by drawing down
all available cash.

Suggested Rules of Procedure .—From this detailed analysis of
the defects of real estate bond financing in the past decade, a
number of specific rules of procedure may be developed to guide
the investor in the future.

In the case of single-family dwellings, loans are generally
made directly by the mortgage holder to the owner of the home,
i.e.y without the intermediary of a real estate mortgage bond
sold by a house of issue. But an extensive business has also
been transacted by mortgage companies ( e.g ., Lawyers Mortgage
Company, Title Guarantee and Trust Company) in guaranteed
mortgages and mortgage-participation certificates, secured on
such dwellings. 1

Where investments of this land are made, the lender should
be certain: (a) that the amount of the loan is not over 66%%
of the value of the property, as shown either by actual recent
cost or by the amount which an experienced real estate man
would consider a fair price to pay for the property; and (6)
that this cost or fair price does not reflect recent speculative
inflation and does not greatly exceed the price levels existing
for a long period previously. If so, a proper reduction must be
made in the maximum relation of the amount of mortgage debt
to the current value.

The more usual real estate mortgage bond represents a par¬
ticipation in a first mortgage on a new apartment house or office
building. In considering such offerings the investor should

1 Since 1933 real estate financing on single-family homes has been taken
over so substantially by the Federal government, through the Federal
Housing Administration (F.H.A.), that practically no real estate bonds of
this type have been sold to investors. Financing on larger buildings has
been greatly restricted. Practically all of it has been provided by financial
institutions (insurance companies, etc.), and there have been virtually no
sales of real estate securities to the general public (to the end of 1939).

FIXED-VALUE INVESTMENTS

143

ignore the conventional “appraised values” submitted and
demand that the actual cost, fairly presented, should exceed the
amount of the bond issue by at least 50%. Secondly, he should
require an estimated income account, conservatively calculated
to reflect losses through vacancies and the decline in the rental
scale as the building grows older. This income account should
forecast a margin of at least 100% over interest charges, after
deducting from earnings a depreciation allowance to be actually
expended as a sinking fund for the gradual retirement of the bond
issue. The borrower should agree to supply the bondholders
with regular operating and financial statements.

Issues termed “first -leasehold mortgage bonds” are in actuality
second mortgages. They arc issued against buildings erected
on leased land and the ground rent operates in effect as a first
lien or prior charge against the entire property. In analyzing
such issues the ground rent should be added to the bond-interest
requirements to arrive at the total interest charges of the prop¬
erty. Furthermore, it should be recognized that in the field of
real estate obligations the advantage of a first mortgage over a
junior lien is much more clean-cut than in an ordinary business
enterprise. 1

In addition to the above quantitative tests, the investor
should be satisfied in his own mind that the location and type
of the building are such as to attract tenants and to minimize
the possibility of a large loss of value through unfavorable
changes in the character of the neighborhood. 2

1 See Appendix Note 21, p. 744, for examples and comment.

* Footnote to 1934 edition: “One of the few examples of a conservatively
financed real estate-bond issue extant in 1933 is afforded by the Trinity
Buildings Corporation of New York First due 1939, secured on two
well-located office buildings in the financial district of New York City.
This issue was outstanding in the amount of $4,300,000, and was secured
by a first lien on land and buildings assessed for taxation at $13,000,000.
In 1931, gross earnings were $2,230,000 and the net after depreciation was
about six times the interest on the first-mortgage bonds. In 1932, rent
income declined to $1,653,000, but the balance for first-mortgage interest
was still about 3K times the requirement. In September 1933 these bonds
sold close to par.”

This footnote and the sequel well illustrate the importance of the
location factor referred to in the text. Despite the improvement in general
business conditions since 1933, the lessened activity in the financial district
resulted in a loss of tenants and a severe decline in rental rates. The net

144

SECURITY ANALYSIS

Real estate loans should not be made on buildings erected
for a special or limited purpose, such as hotels, garages, etc.
Commitments of this kind must be made in the venture itself,
considered as an individual business. From our previous
discussion of the standards applicable to a high-grade industrial-
bond purchase, it is difficult to see how any bond issue on a new
hotel, or the like, could logically be bought on a straight invest¬
ment basis. All such enterprises should be financed at the
outset by private capital, and only after they can show a number
of years of successful operation should the public be offered
either bonds or stock therein. 1

earnings of Trinity Building Corporation failed even to cover depreciation
charges in 1938 and were less than interest charges, even ignoring depreci¬
ation; principal and interest were defaulted at maturity in 1939; the guar¬
antee by United States Realty and Improvement Company, the parent
enterprise, proved inadequate; and the holders were faced with the necessity
of extending their principal and accepting a reduction in the fixed coupon
rate. In this instance an undoubtedly conservative financial setup (a
quantitative factor) did not prove strong enough to offset a decline in the
rental value of the neighborhood (a qualitative factor).

‘The subject of guaranteed real estate mortgage issues is treated in
Chap. XVII.

CHAPTER XI

SPECIFIC STANDARDS FOR BOND INVESTMENT

(Concluded)

RELATION OF STOCK CAPITALIZATION TO BONDED DEBT

The amount of stock and surplus following or junior to a
bond issue expresses the same fact as the excess of resources
over indebtedness. This can be seen at once from the following

condensed typical balance sheet:

Assets, less current lia- Bonded debt. $ 600,000

bilities (net assets)... SI, 000,000 Stock and surplus (stock

equity). 400,000

$1,000,000 $1,000,000

The resultant simple formula is as follows:

Stock equity _ net assets __ ^

Bonded debt bonded debt

Standards Prescribed by the New York Law.—If we are
studying balance-sheet figures, therefore, we can look either
at the net assets or at the stock equity to determine the indicated
coverage or margin above the principal amount of the debt.
The New York statute governing investments of savings banks
employs both approaches in its regulations respecting public-
utility bonds. It stipulates: (1) that the mortgage debt in
question, plus all underlying mortgage debt, shall not exceed
60% of the value of the mortgaged property; and (2) that the
capital stock shall be equal to at least two-thirds of the mortgage
debt. It will readily be observed from the typical balance sheet
just given that these two requirements are broadly equivalent.
Where a company has a substantial unsecured indebtedness,
however, it might meet requirement 1 and not requirement 2,
so that in such cases the second stipulation supplies an added
protection. This point may be illustrated by the following
example:

146

SECURITY ANALYSIS

Mortgaged property.. $10,000,000 Mortgage debt. $ 6,000,000

Working capital. 1,000,000 Debentures. 3,000,000

_ Stock and surplus. 2,000,000

$ 11 , 000,000 $ 11 , 000,000

In this case the mortgage debt is only 60% of the pledged
property but the stock equity is much less than two-thirds
of the mortgage debt. Hence the latter bonds would not be
eligible.

It should be noted that the New York statute considers
only the par or stated value of the stock issues (including, of
course, both preferred and common), and it does not give credit
for the book surplus, which is part of the stockholders 1 equity.
The theory behind this restriction may be that the surplus is
legally distributable to the stockholders, and cannot therefore
be counted on as a permanent protection for the bondholders.
In actuality, however, a utility company’s surplus is almost
invariably invested to a large extent in fixed assets and is not
distributable in cash. Hence, if tests of this kind arc to be
required, the stock-and-surplus figure would appear more logical
than the stock issue alone.

Equity Test of Doubtful Merit in the Case of Utilities.—We

are inclined to question whether any substantial advantage is
gained in the ordinary case by applying the property or stock-
issue test to public-utility bonds. It is unlikely to give any
indication of safety or lack of safety not already shown by the
earnings record. In some few instances, perhaps, the income
exhibit may be satisfactory but the asset coverage unduly small,
and the latter point may suggest that since the company is
earning an exceptionally high rate on its investment, it is vul¬
nerable to unfavorable rate regulation. The primary difficulty,
however, has lain in the lack of dependability of the balance-sheet
figures of property values (and hence of stock equity) as an
indication either of the actual cash investment or of the repro¬
duction value which may be designated as the rate base. But
in recent years the activities of the state commissions and the
S.E.C. have given the public far more accurate balance sheets
than formerly. Even allowing for this improvement, there does
not seem to be sufficient reason to exact a property value or
stock-equity test for public-utility bonds and none for railroad
bonds.

FIXED-VALUE INVESTMENTS

147

There is, of course, no objection to the application of this
stock-equity test (based on book figures) to both railroad and
public-utility obligations, as an added precaution, either regu¬
larly or in special cases where there is reason to doubt the
reliability of the earnings record as a measure of the future
ability to meet bond interest* If this test is applied, it should
be pointed out that a maximum ratio of 60% of debt to 40%
of stock and surplus is proportionately more severe than a
minimum earnings ratio of 1% times interest charges. It would
be more consistent, therefore, to admit a bonded debt as high
as 75% of the property value, or three times the amount of the
stock and surplus.

Importance of a Real-value Coverage behind a Bond Issue.—

Our principal objection to the property-value criterion arises
from the undoubted fact that the book valuations of fixed assets
are highly unreliable as indications of the safety of a bond.
But on the other hand we are convinced that a substantial
margin of going-concern value over funded debt is not only
important but even vitally necessary to assure the soundness of
a fixed-value investment. Before paying standard prices for
bonds of any enterprise, whether it be a railroad, a telephone
company, or a department store, the investor must be convinced
that the business is worth a great deal more than it owes. In
this respect the bond buyer must take the same attitude as the
lender of money on a house or a diamond ring, with the important
difference that it is the value of the business as an entity which
the investor must usually consider, and not that of the separate
assets.

Going-concern Value and Earning Power. —“The value of
the business as an entity ” is most often entirely determined
by its earning power. This explains the overshadowing sig¬
nificance that has come to be attached to the income exhibit, for
the latter reveals not only the ability of the company to meet
its interest charges, but also the extent to which the going value
of the business may be said to exceed the principal of the bond
issue. It is for this reason that most investors have come to
regard the earnings record as the only statistical or quantitative
test necessary in the selection of bond issues. All other criteria
commonly employed are either qualitative or subjective (t.e.,
involving personal views as to the management, prospects, etc.).

148

SECURITY ANALYSIS

While it is desirable to make the tests of safe bonds as simple
and as few as possible, their reduction to the single criterion
of the margin of earnings over interest charges would seem to
be a dangerous oversimplification of the problem. The earnings
during the period examined may be nonrepresentative, either
because they resulted from definitely temporary conditions,
favorable or the reverse, or because they were presented in such
a way as not to reflect the true income. These conditions are
particularly likely to occur in the case of industrial companies,
which are subject both to greater individual vicissitudes and to a
smaller degree of accounting supervision than is true of railroads
and utilities.

Shareholders' Equity Measured by Market Value of Stock
Issues — a Supplemental Test. —We feel, therefore, that it is
essential, in the case of industrial bonds at least, to supplement
the earnings test by some other quantitative index of the margin
of going-concern value above the funded debt. The best
criterion that we are able to offer for this purpose is the ratio
of the market value of the capital stock to the total funded debt.
Strenuous objections may, of course, be leveled against using the
market price of stock issues as a proof of anything, in view of the
extreme and senseless variations to which stock quotations are
notoriously subject. Nevertheless, with all its imperfections,
the market value of the stock issues is generally recognized as a
better index of the fair going value of a business than is afforded
by the balance-sheet figures or even the ordinary appraisal. 1

Note carefully that we are proposing the use of stock prices
for the restricted purpose only of ascertaining whether or not
a substantial equity exists behind the bond issue. This is by
no means tantamount to stating that the price is always an
exact measure of the fair or intrinsic value. The market-
price test is suggested as a rough index or clue to the existing
values, and it is to be employed only as a supplement—but an
important supplement—to the more carefully scrutinized figures
supplied by the earnings record. 2

1 The liquidating value, arising chiefly from the net current assets, may at
times exceed the market price, but this point is seldom of significance in the
selection of high-grade investments.

* Note that the tests of safety suggested by the New York State Bankers

FIXED-VALUE INVESTMENTS

149

The utility of the market-price test in extreme cases is unques¬
tionable. The presence of a stock equity with market value
many times as large as the total debt carries a strong assurance
of the safety of the bond issue’, 1 and conversely, an exceedingly
small stock equity at market prices must call the soundness
of the bond into serious question. The determination of the
market value of the stock equity, and its comparison with
the total amount of funded debt, is a well-established feature
of bond analysis, and it was formerly included in bond-offering
circulars (when the showing made was satisfactory). We recom¬
mend that this calculation be made a standard element in the
procedure of bond selection, especially for industrial issues; and
that minimum requirements under this heading be set up which
will serve as a secondary quantitative test of safety.

Minima for the Stock-equity Test —What should be the
normal minimum relationship between stock values and funded
debt? It is difficult to answer this question satisfactorily
from actual experience because of the wide changes in stock
prices and the variations in the exhibits of individual companies.
A theoretical rule can be established by assuming, somewhat
arbitrarily, that railroad and utility stocks should earn about
times as large a percentage on their price as the interest rate on
their bonds; whereas industrial stocks should earn twice as much
as the interest rate on their bonds. These assumptions would
produce the following arithmetical relationship 2 between the
minimum interest coverage on the one hand and the stock-to-
bond ratio on the other:

Association, in collaboration with Standard Statistics Company, include in
the case of railroad and industrial bonds the market price of the stock equity,
designated as the "most realistic measure of debt position”— i.e., of the
value of the junior capital. See our more detailed discussion of these tests
in Appendix Note 22, p. 745.

1 See our discussion of Fox Film Corporation 6 % Notes, as of December
1933 in Appendix Note 67, p. 819.

1 To place both tests on the same arithmetical basis, the stock-value ratio
should really be expressed as the ratio of total capitalization (bonds at par
plus stock at market) to bonds. Thus calculated, the minimum "capital¬
ization coverage” required would be, respectively, 1M> 1 Ht and 2. The
student may use whichever of the two methods seems more convenient to
him; their implications are, of oourse, identical.

150

SECURITY ANALYSIS

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FIXED-VALUE INVESTMENTS

151

Type of
enterprise

Minimum number
of times fixed
charges earned
(Average inter¬
est coverage)

Minimum ratio of stock
value to bonded debt
(Stock-value ratio)

Public utilities

$1 of stock to $2 of bonds

Railroads.

$1 of stock to $1.50 of

bonds

Industrials....

$1 of stock to $1 of bonds

On page 150 we present a summarized exhibit of a public
utility, a railroad, and an industrial company, as of December 31,
1938, which will support in a general way the relationships
suggested above.

Income Bonds Equivalent to Stock Equity. —In Chap. IX
we pointed out that since interest on income bonds is not a
fixed charge, it need not be included in the total charges on which
coverage is to be calculated. Similarly, the principal amount of
such bonds is not to be included in the total funded debt that
is to be compared with the stock equity. Not only is this so,
but it is true also that junior income bonds (of long maturity)
are so close in their character to preferred stock that their
market value may properly be considered as part of the stock
equity (or rather “income bond and stock equity”) junior to, and
protecting, the fixed-interest bonds.

Example:

Colorado Fuel and Iron General (First) 5s, due 1943, price June 30, 1939,

103^ yielding 3.90%

Amount outstanding. $ 4,483.000

Income bond and stock equity June 30, 1939:

$11,035,000 Income 5s due 1970 ® 45.. 4,966,000

564,000 shares common stock @ 123-2 7,050,000

315,000 stock purchase warrants ® 4 }/± 1,339,000

Total equity. $13,355,000

In this case the technical position of the 1st mortgage 5s is
entirely different by virtue of the fact that the junior lien is
an income bond than it would be if the latter carried fixed
interest. That this is true is shown in striking fashion by
reference to the situation prior to the reorganization of 1936.

152

SECURITY ANALYSIS

In the former setup the First 5s were followed by a large fixed-
interest bond issue, the requirements of which (including their
maturity) precipitated a receivership in 1933, following which the
First 5s sold as low as 30.

Significance of Unusually Large Stock-value Ratio. — As we

have previously intimated, if the stock-value ratio were always
proportionate to the interest coverage, in the manner suggested
in the foregoing table, there would be no reason to apply both
tests, since the passing of one would assure passing of the other.
Such is not the case, however, and we must accordingly consider
what is implied when the stock-value ratio gives a substantially
different indication from that given by the interest coverage.
Let us assume first that the earnings picture is not completely
convincing but that the stock-value ratio is considerably higher
than our minimum requirement.

Example: Referring to the Fairbanks-Morse example on page
130, the investor would be impressed by the fact that at the
lowest market price in 1938 the stock-equity ratio was more than
2 to 1, (about $12,000,000 market value of stock behind $5,600,-
000 of bonds). This evidence of strength might well dispel any
doubt arising from the inadequacy of the straight ten-year
average.

Significance of a Subnormal Stock-value Ratio. —The opposite
case is that in which the interest coverage may be called satis¬
factory but the stock-value ratio is substantially below the
minimum required.

Examples: The problem here may be better understood by the
use of two contrasting examples, one taken in the midst of depres¬
sion and the other at the peak of recovery.

The first example is that of Inland Steel 4J^s, due 1978,
which sold in September 1932 at 82, to yield 5.6%. The relevant
data appear in the table on page 153, together with corresponding
figures for Crucible Steel 5s, due 1940, which are supplied for
comparison.

It will be seen that the Inland Steel issue met our earnings
test (based on a 6J^-year average) but failed to meet our stock-
ratio test. Most investors would reason that the bond was a
very sound and attractive investment at the time, because (1)
Inland Steel was one of the best steel companies, with a fine
predepression record; and (2) the 1932 figures, both for earnings

FIXED-VALUE INVESTMENTS

153

COMPARATIVE EXHIBIT OF TWO BOND ISSUES, SEPTEMBER, 1032

Item

Inland Steel 4H«. due 1078 and 1081
Price 82, yield 5.6%

Crucible Steel 6s, due 1040

Price 60, yield 13.4%

Annual interest charge

S 1,800,000

3 675,000

Earned for interest by years:

1032 (first half) .. .

496,000(d)

/.348.000(d)

1031..

3,126,000

/.330.000(d)

1030 .

7,793,000

4,542,000

1020

13,042,000

8.364,000

1028

10,560,000

5.840,000

1027

7,482,000

5.844,000

1026 . .

7,851,000

6,787,000

6^-year average ....

S 7,595,000

3 4.400.000

Interest coverage . .

4 6 times*

7 1 times*

Bonded debt

342,000,000

313.500,000

Stock value:

Preferred ...

250,000 sh.@ 30 - 37,500.000

Common

1,200,000sh.@ 20 - 324,000,000

450,000 sh.@ 17 - 37,650,000

Total stock value

324,000,000

315,100.000

Stock-value ratio

0 57 to 1

1 12 to 1

* Adjusted for changes m the funded debt during the period.

and for stock prices, were so abnormal as to afford no guide to the
safety of the bond issue. The fact that the company’s earnings
recovered later on and that the bonds were called at a premium
in 1936 would be pointed to as confirming the soundness of this
view.

But the weakness of the reasoning lies in the fact that it
required certain assumptions as to the future which should not be
needed to justify the purchase of an investment bond. (Note
that under the conditions of 1932, the price of 82 for Inland Steel
4^£s put them distinctly in the investment class.) This should be
clear if we compare the exhibits of the Inland and Crucible issues.
It will be seen that both the earnings coverage and the stock-
value ratio were better for the Crucible issue, yet the yield
on the latter was twice as high as for the Inland bond. The
purchaser of the Inland Steel 43^s would have to assume not only
that the 1932 conditions were transitory—a necessary assumption
if there was to be any buying of securities—but also (1) that the
price of Inland Steel stock was much too low and (2) that the
price of Crucible Steel stock issues was much too high. For
unless the Inland stock was selling too low, the Inland bonds
could not be considered safe; and unless the Crucible shares were

154

SECURITY ANALYSIS

selling too high, he would have been much better advised to buy
the lower priced Crucible bonds. This would seem to be
entirely too complicated and doubtful a basis for a straight bond
investment.

It is true also, as a general rule, that no bond investment
should be made if it requires the assumption that the common
stock is selling too low at the time. If the investor is right in that
judgment of the stock value, it would certainly be more profitable
to buy the stock than the bonds. If he is wrong as to the stock
value, he runs great risk of having made a poor bond purchase.

The fact that the Inland Steel bonds were later repaid at an
advance of some 20 points does not invalidate our logic but rather
confirms it; for by the same time Inland common had advanced
over fourfold in value and the Crucible Steel 5s had risen from 60
to 102. We advert once more to our controlling principle that
bond investment is a negative art. This discussion was not
intended to imply that the Inland Steel 4}^s were a poor invest¬
ment—the contrary is clearly the case—but we wished to point
out that a logical examination of the picture at the time would
not have led to an affirmative verdict for that issue, particularly
in view of the alternative investments offered.

A Second Example: We may buttress our argument further by
introducing an opposite type of illustration—the Brooklyn
Manhattan Transit 43^s, due 1966, which sold at 104 to yield
4.27% in January 1937. The average earnings coverage here
was about adequate, judged by our minimum standard for rail¬
road bonds. However, the stock-value ratio—even at the high
general market level then obtaining—showed less than 40 cents
of stock for each dollar of bonds. This meant in essence that the
stock market w^as not sufficiently optimistic as to the prospects
of the B.M.T. to value the equity issues at our minimum require¬
ment in relation to total debt. The bond buyer would have been
well advised to take this deficiency in the secondary test as a hint
to look elsewhere for his 43^ % investments. (By December of
that same year the bonds had fallen to 44.)

Our reference to the stock market’s valuation of future
prospects of Brooklyn Manhattan Transit suggests that the
stock-equity test is not merely an additional quantitative
criterion of bond safety but that it is in good part a qualitative
index as well. A third function of the stock-value test may be to

FIXED-VALUE INVESTMENTS

155

throw justifiable doubt on the complete accuracy of the reported
earnings figures. In the case of the B.M.T. a careful study of
the offering prospectus would have revealed a wide difference
between depreciation and amortization charges as shown on the
reports to security holders and as taken on the income tax
returns. The more conservative depreciation basis would have
reduced the interest coverage to well below our suggested
minimum.

Stock-value Ratio for Railroad and Public-utility Companies.—

In the case of industrial companies the stock-value ratio may be
easily calculated. Railroads and public utilities, however, are
likely to present various complications. In addition to the
bonded debt as shown in the balance sheet, it may also be neces¬
sary to consider rental obligations equivalent to debt and pre¬
ferred stocks of subsidiaries ranking ahead of parent company
bonds. These difficulties militate somewhat against the use of
the stock-value ratio test for railroad and utility bonds. How¬
ever, we believe that a careful investor should apply the stock-
value test in these fields as well as to industrials. As we shall
point out in the next chapter, the stock-value test would have
been of great utility in guarding against the mistaken purchase of
many railroad bonds at high prices during 1935-1937. In the
next chapter, also, wc shall describe the procedure of capitalizing
the fixed charges to arrive at a fair estimate of total debt when
the balance sheet may not tell the whole story.

Stock-value Test Not to Be Modified to Reflect Changing
Market Conditions.—The question arises: To what extent should
the stock-value ratio test be modified to reflect changing market
conditions? It would seem proper to expect, and therefore to
demand, a higher relative market value for the stock behind a
bond issue when times are good than during a depression. If
$1 of stock to $1 of bonds is taken as the “normal” requirement
for an industrial company, would it not be sound to demand,
say, a $2-to-$l ratio when stock prices are inflated, and conversely
to be satisfied with a 50-cent-to-Sl ratio when quotations are
far below intrinsic values? But this suggestion is impracticable
for two reasons, the first being that it implies that the bond
buyer can recognize an unduly high or low level of stock prices,
which is far too complimentary an assumption. The second is
that it would require bond investors to act with especial caution

156

SECURITY ANALYSIS

when things are booming and with greater confidence when times
are hard. This is a counsel of perfection which it is not in human
nature to follow. Bond buyers are people, and they cannot be
expected to escape entirely either the enthusiasm of bull markets
or the apprehensions of a severe depression.

We should not propose a rule, therefore, by which investors
are to require a larger than usual stock-value ratio when prices
are high; for such advice will not be followed. (But if the bond
buyer is personally convinced that stock prices are dangerously
high, he would be wise to insist on a stock-equity coverage well
above our minimum ratios.) Nor shall we propose the opposite
rule for bear markets, particularly because by diligent search it
will always be possible to find some investments that meet all
the normal tests even under depressed conditions . 1

Summary op Minimum Quantitative Requirements Suggested for
Fixed-value Investment

1. Size of obligor:

Municipalities: population. 10,000

Public utilities: gross revenues. $2,000,000

Railroads: gross revenues. 3,000,000

Industrials: gross revenu es. 5,000,000

2. Interest coverage:

Public-utility bonds: (7-year average). 1% times

Railroad bonds: (7-year average).2 times

Industrial bonds: (7-ycar average).3 times

Real estate bonds: (dependable estimate). 2 times

3. Value of property:

Real estate bonds: Fair value of property (based on actual sales in a
noninflated market) must be 50% more than the amount of the
bond issue.

Investment trust bonds: Similar ratio, using market value of assets.

4. Market value of the stock issues:

Public utilities. 50 % of the bonded debt

Railroads. 06 H % of the bonded debt

Industrials. 100 % of the bonded debt

l For example: In September 1932 General Baking 5J^s could have been
bought to yield 6%. Their average earnings coverage was twenty times
interest charges; in the first half of 1932 interest was covered fourteen times.
The stock-value ratio was 6 to 1.

CHAPTER XII

SPECIAL FACTORS IN THE ANALYSIS OF RAILROAD
AND PUBLIC-UTILITY BONDS

RAILROAD-BOND ANALYSIS

The selection of railroad bonds can be made a process of
extreme complexity. The reports of the carriers to the Inter¬
state Commerce Commission contain voluminous data on the
financial and physical condition of the railroads, which supply
material for elaborate analysis. A really thorough study of a
railway report would devote attention to the following items,
among others:

1. Financial:

a. Composition and trend of operating revenue.
h. Ratio of maintenance expenditures to gross.

c. Relative amount and trend of transportation expenses.

d. Character of “other income.”

c. Coverage for, and relative growth of, interest and other deductions.

2. Physical:

a. Location.

b. Amount of double and third track.

c. Weight of rail.

d. Character of ballast.

e. Amount and capacity of equipment owned.

3. Operating:

a. Character and density of traffic.

b. Average haul and average rate received.

c. Trainload.

d. Fuel costs.

e. Train- and car-mile operating costs.

/. Maintenance charges per unit of equipment.

In addition to the above items affecting the railroad as a whole,
a special study can be made of the mileage covered by the
mortgage lien under consideration. 1

1 Elaborate graphic portrayal of railroad mortgage liens, the specific
trackage covered, etc., together with supporting data and descriptions, are
provided by White and Kemble’s Atlas and Digest of Railroad Mortgages,

157

158

SECURITY ANALYSIS

Elaborate Technique of Analysis Not Necessary for Selection
of High-grade Bonds. —Comprehensive analyses of this kind
are actually made by the investment departments of large
financial institutions which purchase railroad bonds. They are,
however, not only clearly beyond the competence of the individual
investor, but in our opinion they are hardly consistent with
the true nature of high-grade bond investment. The selection
of a fixed-value security for limited-income return should be,
relatively, at least, a simple operation. The investor must
make certain by quantitative tests that the income has been
amply above the interest charges and that the current value
of the business is well in excess of its debts. In addition, he must
be satisfied in his own judgment that the character of the enter¬
prise is such as to promise continued success in the future, or
more accurately speaking, to make failure a highly unlikely
occurrence.

These tests and this expression of judgment should not require
a highly elaborate technique of analysis. If the investor in
railroad bonds must weigh such factors as a favorable trainload
trend as against a poor diversification of traffic handled, he is
called upon to exercise penetration and skill out of all proportion
to the reward offered, viz., a fixed income return of from 2% to
4)^%. He would certainly be better advised to buy United
States government securities, which yield a lower return but are
6afe beyond question, or else to let one of the large savings banks
invest his money for him with the aid of its extensive statistical
staff.

Recommended Procedure. —The complexities associated with
railroad-bond analysis have arisen naturally—but in our view,
rather illogically—from the wealth of data available for study.
The fact that a mass of figures is obtainable does not mean that
it is necessary, or even advantageous, to dissect them. We
recommend that the buyer of high-grade railroad bonds confine

covering all of the railroads of major importance in the United States.
More exhaustive study of the character and volume of traffic originating on
and transported over particular sections of the road securing individual
mortgage issues is greatly facilitated by examination of the “ Freight Traffic
Density Charts** and data assembled by H. H. Copeland and Son of New
York City, which are distributed privately by them among a large group of
investment institutions.

FIXED-VALUE INVESTMENTS

159

his quantitative study to the coverage of fixed charges (with
due attention to the trend of earnings and the adequacy of
maintenance expenditures) and to the amount of the stock
equity. If he desires to be particularly careful, he will probably
be better advised to increase his minimum requirements on these
two points, rather than to extend his statistical tests to numerous
other features of the annual reports.

It may make our viewpoint clearer if we add that such elaborate
analyses may at times be of real value to the purchaser of specula¬
tive railroad bonds or stocks, as aids to his judgment of what the
future will bring. But the whole raison d'&tre of fixed-value
investment is opposed to any primary reliance upon surmises
as to the future, since the field for exercising such judgment
must logically be among those issues which offer possibilities
of gain as a reward for being right, commensurate with the
penalties attached to being wrong.

Technical Aspects of Railroad-income Analysis. —The applica¬
tion of the interest-coverage test to railroad bonds involves a
few technical questions which require attention. Railways
have various kinds of fixed charges which are obligations equiva¬
lent to bond interest and which clearly should be included with
such interest in calculating the margin of safety. There are
also certain deductions which partake to some extent of the
nature of fixed charges and to some extent also of operating
expenses. Furthermore, there are credits designated as “other
income,” such as bond interest received, which may properly
be considered as offsets to interest paid—at least for the purpose
of comparison with other roads. In the following schedule we
allocate the more important items of this character that are
encountered in railroad statements.

1. Bond interest and equivalent charges.

a. Interest on funded and unfunded debt.

6. Rent for leased lines.

c. Joint-facility rents (net debit).

2. Deductions midway between fixed charges and operating expense.

o. Hire of equipment (net debit). 1

b. Miscellaneous rents and miscellaneous deductions.

1 Since Jan. 1, 1936, the I.C.C. definition of “fixed charges” for the pur¬
poses of railroad-income accounts has included rent paid for the use of equip¬
ment. But this definition is not followed, as yet, in the calculation of
fixed-charge coverage by the financial manuals and services.

160

SECURITY ANALYSIS

3. Credits that may be partially offset against bond interest (in order of
dependability).

a. Bond interest received; rent for leased lines; joint-facility rents (net

credit).

b. Hire of equipment (net credit); dividends received.

c. Miscellaneous nonoperating income.

Methods of Computing Fixed-charge Coverage. —Considerable
argument might be indulged in as to the most scientific way of
handling all these items in order to arrive at the best formulation
of the fixed charges. The matter may be simplified, however,
by bearing in mind that the bond buyer is not interested in
exactitude, but rather in reasonable accuracy. After all, the
data he is dealing with represent past history, the sole value of
which is to serve as a hint or clue to the future. For such a
purpose refinement of calculation is of little benefit. We
suggest that for railroad bonds the necessities of the case with
respect to interest coverage may be met by setting up a double
test, and requiring that the minimum margin be shown by each.
The method proposed is as follows:

Test A. Number of times fixed charges are earned:

Fixed charges = gross income — net income,
Times fixed charges earned

gross income

gross income — net income

Note: “Gross income” is the “net after rents” plus “other income.” “Net
income” is the balance available for dividends . 1

Test B . Number of times net deductions are earned:

Net deductions * railway operating income — net income.

j railway operating income

Times net deductions earned = —---r-r-

railway operating income — net income

Note: “Railway operating income” is the same as a “net after taxes,” i.e.
the gross revenues minus operating expenses and taxes.

It is necessary to apply only one of these two tests, viz., the
more stringent one, which may readily be identified by inspection.
The rule is as follows: If gross income exceeds net after taxes,

1 The figure for fixed charges as computed by Standard Statistics Com¬
pany excludes some of the minor items, which are subtracted from gross
income first, under the caption of “miscellaneous deductions.” Our method
is simpler, but the Standard Statistics calculation will give almost the same
result, so that if their results are available they may as well be used.

FIXED-VALUE INVESTMENTS

161

Calculation of Margin of Safety for Railroad Bonds
(Unit $1,000; calendar year 1931)

Item

Chesapeake
& Ohio

Chicago

Great

Western

Northern

Pacific

1. Gross revenue.

$119,552

$20,108

$62,312

2. Net after taxes (railway operating

income).

3. Equipment and joint-facility rents.

35,417
dr. 88

4,988
dr. 2,417

3,403
cr. 3,398

4 . Net after rents (net railway operating

income).

6 . Other income.

35,329

2,269

2,571

196

6,801

16,853

6 . Gross income.

S 37,598

$ 2,767

$23,654

7 . Interest and other fixed charges.

10,902

1,866

14,752

8 . Balance for dividends (net income)...

$ 26,696

$ 901

$ 8,902

Chesapeake and Ohio, 1931

Gross income exceeds net after taxes. Therefore use fixed-charges test

(6) 37,598

(Test A). Fixed charges earned

= 3.45 times

(6) - (8) 10,902

Chicago Great Western, 1931

Net after taxes exceeds gross income. Therefore use net-deductions test

(2) 4,988

(Test B ). Net deductions earned —

(2) - (8) 4,087

= 1.22 times

Northern Pacific, 1931

Gross income exceeds net after taxes. Therefore use fixed-charges test

(Test A). Fixed charges earned = = 1.60 times

14 , (06

Notes on the Foregoing Tests

1. Chesapeake and Ohio represents the typical exhibit in which the results
of both tests would have pointed to the same conclusion—in this case to the
presence of a satisfactory margin of safety for the bonds.

2. In the case of Chicago Great Western, Test A , which is ordinarily
applied, would not adequately reflect the burden of the unusually large
rental deductions. Their effect is shown by Test B } and in accordance with
our suggestion this less favorable result should be the one considered by the
investor.

3 . Northern Pacific presents the opposite situation. Its other income
has been exceptionally large as compared with the bond interest, so that in
most years the net deductions figure out as a credit. In this case the
investor should follow the results of Test A t and consider Test B as a second¬
ary indication of strength.

162

SECURITY ANALYSIS

apply the fixed-charges test (Test A). If net after taxes exceeds
gross income, apply the net-deductions test (Test B ). The
application of these alternative tests will be clear from the
examples as shown on page 161.

The Pennsylvania Railroad’s reports offer an exceptional case,
in that the larger part of its substantial other income is a direct
offset against the fixed charges. These other-income items
consist of interest and guaranteed dividends received on securities
of the system itself which are owned by the parent company,
so that the same items appear later as interest and rentals paid.
In 1938 these offsetting amounts totalled some $30,298,074.
They should properly be eliminated from the statement alto¬
gether. The effect of their inclusion was to reduce the indicated
coverage under the fixed-charges test, as the following will show:

1938

Fixed-charges test

Net deductions test

As reported

As corrected

Gross income.

Fixed charges.

Times earned.

$93,559,000

82,513,000

1.13

$63,261,000

52,215,000

1.21

Net after taxes $66,112,000
Net deductions 55,066,000
. 1.20

Times earned, 10-
year average....

1.42

1.67*

. 1.68

* Amount of correction estimated for years prior to 1932.

In this case the net-deductions test afforded a fairer criterion
than the fixed-charges test uncorrected. Where an especially
careful analysis is to be made, the reported figures should be
adjusted as above indicated, on the basis of the available facts.

Bearing of Maintenance Expenditures upon Fixed-charge
Coverage.—There are two important items in railroad accounting
which are subject in some degree to arbitrary determination by
the management, and which may therefore be treated in any one
year in such a manner as to produce deceptively favorable or
unfavorable results. The first of these is the maintenance
account. If unduly small amounts are spent on upkeep of road
and equipment, the net profits are thereby increased at the
expense of the property, and the balance reported as available
for fixed charges does not fairly represent the earning power
during the period under review. Bond buyers might do well

FIXED-VALUE INVESTMENTS

163

to examine the maintenance ratio (z.e., the percentage of gross
revenues expended on upkeep of way and rolling stock) in order
to make sure that it is not suspiciously below standard. Unfortu¬
nately it is difficult to determine with any degree of assurance
just what should be considered a standard maintenance rate for
different groups of carriers. Prior to 1931 a figure of about 33%
of gross operating revenues was so generally and consistently
reported that it undoubtedly could be considered a norm, any
wide deviation from which deserved special study. 1 Since 1930,
however, there has been a moderate decline in this percentage
figure concurrently with a major shrinkage in the gross operating
revenues against which it is computed. As a result, actual dollar
expenditures for maintenance have been cut nearly in half.
(Somewhat surprisingly, the maintenance-of-way outlays in
dollars—which presumably are not so subject to curtailment on
account of smaller traffic—suffered a decline of 51 % in 1933-1937
as against 1926-1930, whereas maintenance of equipment costs
were reduced by 39%.)

On the other side must be set the undoubted improvement in
the technology of maintenance as shown in the use of more
efficient methods and more durable materials. 2 The cost of
maintaining railroad property in adequate condition is now
substantially less than it was prior to 1931. But how much
less we cannot say with assurance; hence the difficulty of deter¬
mining whether the average ratio of about 30V£% on the reduced
gross of 1933-1937 (shown by all Class I Railroads) is sufficient
to reassure the bond buyer against the existence of undermain¬
tenance. Our judgment leans to the view that this figure is
rather low 3 and that a somewhat higher ratio—say 32%—might
better be taken as the investors norm.

1 Geographical differences, formerly productive of rather wide variations
in the customary maintenance ratio, were not of great importance in the years
1926-1930. See material on this point and others relating to railroad main¬
tenance in Appendix Note 23, p. 749.

* Many detailed examples on this point are given in an address of L. A.
Downs, president of the Illinois Central Railroad, delivered Dec. 3, 1936,
and reprinted by the Association of American Railroads.

* This conclusion is supported by the replies of the railroads themselves to
a circular of the Interstate Commerce Commission, dated Dec. 12, 1938, in
which they estimated that a total of $283,800,000 of deferred maintenance
existed on their lines at the end of 1938. The replies generally distinguished

164

SECURITY ANALYSIS

If this suggestion is accepted, it would mean that when con¬
sidering bonds of a railroad spending less than 32% of its gross
on maintenance the investor will either: (1) make such further
study as will convince him that the lower rate is adequate or (2)
adjust the reported earnings to a hypothetical 32% ratio, thus
reducing the earnings coverage correspondingly. If the coverage
is satisfactory after this correction, it may be assumed that the
possible undermaintenance is not in itself a serious enough factor
to impair the safety of the bond.

Nonrecurring Dividend Receipts. —A second item which some¬
times repays scrutiny is that of Dividends Received. When a
railroad controls subsidiary companies, it is possible to draw out
accumulated profits at irregular intervals in the form of special
dividends paid to the parent company. The effect of such trans¬
actions is to overstate the actual earning power of the parent
company for the year in which the subsidiary's special dividend
was received. 1

Excessive Maintenance and Undistributed Earnings of Sub¬
sidiaries.—Railroad reports will also disclose the opposite
situation at times, viz., excessive maintenance expenditures or
the existence of large current earnings of subsidiaries not paid
over to the parent company. The effect of such accounting is to
understate the true earning power of the carrier examined.
Matters of this kind are of considerable interest in the analysis
of stock values, but the bond buyer's concern with such factors
is of secondary character. In general he should not permit them
to reverse an otherwise unfavorable verdict as to the safety of
the bond, but he should recognize that their presence gives added
attractiveness to bond issues which show adequate security
without taking them into account. 2

Analysis of Low-priced Railroad Bonds. —A study of specu¬
latively priced railroad bonds will properly include consideration

between maintenance sufficient for safe and economical operation, which they
contended had been performed, and maintenance necessary to bring the prop¬
erty to a satisfactory engineering standard. (See summary of return on
Statistical Series Circular 26, published as Statement 3911 by the Bureau of
Statistics of the Interstate Commerce Commission, March 1939.)

1 This and allied phases of accounting having to do with income of a
nonrecurring character are considered in detail in Chaps. XXXI to XXXIII
(see especially Chap. XXXIII, p. 406, where several examples are given).

* See Appendix Note 24, p. 761, for examples.

FIXED-VALUE INVESTMENTS

165

of many factors in addition to those just discussed. Under our
broad principles of arrangement, consideration of this subject
should be deferred to our later chapter on speculative senior
securities. It seems preferable, to deal with it here, however, in
order not to break up our treatment of railroad-bond analysis.
Many bond buyers may be moved also to carry the analysis of
investment issues further than we suggest is necessary, and to be
guided in their selection among all eligible issues by more detailed
considerations of operating, traffic and financial statistics.

More exhaustive study of a railroad-bond issue falls under
two headings: (1) the showing and prospects of the road as a
whole and (2) the position of the individual bond issue.

Under the first division will come, in addition to the basic
points already outlined, such matters as the character of the
traffic and the efficiency of operation.

Character of Traffic .—On this score a significant change in
viewpoint has been forced on the investor in the last generation.
Formerly, chief emphasis was laid upon diversification of traffic
and upon a liberal percentage of better paying classes— e.g.,
miscellaneous and less-than-carload lot shipments. More recent
developments have proved this older viewpoint unsound. The
higher rate classes of traffic have turned out to be especially
vulnerable to truck competition; and some of the roads with the
“choicest” quality of traffic have fallen behind most since 1929.
At the other extreme we find that the few consistently profitable
carriers have been mainly the eastern soft-coal lines—Chesapeake
and Ohio, Norfolk and Western, Virginian, and (to a lesser extent)
Western Maryland—which have concentrated on a single type of
low-rate freight movement which they have been able to handle
with extraordinary economy. 1

By contrast, the anthracite carriers have had a very disap¬
pointing and difficult time, due to a severe decline in the use of
hard coal because of fuel-oil competition. The complete change
in the relative position of the hard- and the soft-coal carriers

l The operating ratio of Chesapeake and Ohio in 1937 was only 56.95%
as compared with 74.87 % for all Class I railroads. This characteristic
places the eastern soft-coal carriers in a group apart—almost in a different
industry. Incidentally, they have been greatly favored by the growth of
output of their shippers—largely in the Pocohantas field—at the expense of
higher cost mines elsewhere.

166

SECURITY ANALYSIS

between 1923 and 1938 is shown graphically in the following
table and constitutes a warning to the security buyer not to
accept the present or the past as a guarantee of the future.
(This warning may be applicable to the soft-coal roads them¬
selves, whose prosperity could conceivably vanish as did that
of the anthracite carriers. The contrast between the continuing
depression in the bituminous industry and the dazzling prosperity
of the soft-coal carriers may have significance for the future.)

Financial Statistics op Soft- and Hard-coal Carriers in 1923-1927

and 1934-1938
(000 omitted)

1923-1927

1934-1938

Pocahontas soft coalers: 1

Total operating revenues.

$1,334,162

$1,097,739

Net railway operating income.

330,036

381,364

Net income (balance for dividends).

250,465

315,053

Hard coalers:*

Total operating revenues.

2,393,777

1,374,607

Net railway operating income.

401,784

195,975

Net income (balance for dividends).

289,608

18,616(d)

1 Totals for the Virginian; Chesapeake and Ohio; Norfolk and Western.

5 Totals for Central Railroad of New Jersey, Delaware and Hudson; Delaware, Lacka¬
wanna and Western; Erie; Lehigh Valley; Reading.

Because of the loss of light traffic to motor trucks and of
passenger traffic to automobiles and buses, the railroads as a
whole have become more dependent than formerly on heavy
traffic— e.g.y coal, iron and steel, other minerals, stone, sand, etc.
Their prosperity is more tied up than formerly with activity in
the capital-goods industries. Hence, taken as a whole, they are
now handicapped both by a definite diminution of their average
traffic and by an added degree of year-to-year variability in
the traffic that remains.

It is not difficult, perhaps, to obtain a clear view of the traffic
situation as it has developed on the railroads generally and on
the individual lines. But the application of this knowledge
to the future, and the splection of specific bond or stock issues
based thereon, is far from a simple process. 1 It may be assumed

1 See, for example, “Why Railroads Show Diverse Trends,” by E. S.
Adams in Barron'* for Nov. 21, 1938. It is suggested that “long-term

FIXED-VALUE INVESTMENTS

167

that traffic developments to date are fully reflected in both
operating results and security prices. Can the investor go
further and form a dependable judgment as to what classes of
business are due to suffer still greater losses to competitors,
which ones are relatively immune, and which may even be built
up or regained? It is undoubtedly part of the speculator’s
function to arrive at conclusions on such matters as these.
But we must express doubt whether the facts and their implica¬
tions are sufficiently definite to form a basis for what may
properly be called an investment judgment . Hence we must
reiterate our view that the purchase of railroad bonds for invest¬
ment must be motivated primarily by an adequate margin of
safety actually demonstrated and that expectations as to future
traffic developments should play only a cautionary role.

Operating Efficiency .—The measures of operating efficiency
generally considered are the following: Operating Ratio; Trans¬
portation Ratio; Average Trainload and Carload; Average Car
Miles per Day; Ratio of Empty Mileage to Total Mileage; Fuel
Consumption per Locomotive Mile.

The operating ratio is the ratio of all operating expenses,
excluding taxes, to gross revenues. The transportation ratio
applies only to those costs classified as “transportation expenses.”
In our opinion a more useful criterion than either of these would
be the ratio to gross of all operating expenses except maintenance
but including taxes. This might be called the “other operating-
expense ratio.” Maintenance outlays are separated because
they are generally regarded as an indication of the liberality
rather than the efficiency of the management. Allowance must,
of course, be made for the lower maintenance requirements of
some carriers in relation to their revenues— c.g., the soft coalers.
Some studies may also be attempted to determine whether a
given road is accomplishing a physical unit of maintenance
cheaply or expensively, but this is a difficult subject on which to
reach dependable conclusions.

The other items are self-explanatory. A high average train¬
load and carload, high car mileage per day, low mileage of
“empties,” low fuel consumption, are all obvious desiderata.

traffic trends should be given most weight in assessing the investment merits
of individual issues.’* But the article itself does little more than point out
why certain changes in relative values have taken place in the past.

168

SECURITY ANALYSIS

However, the usefulness of these data is diminished by the fact
that they are all pretty well reflected in the transportation ratio,
so that one must beware of emphasizing the same point twice.
It may also be an open question if a road making a rather poor
showing in these respects may not present a more rather than a
less attractive opportunity, provided these disadvantages are
fully reflected in the price of its securities—since it may be easier
to produce improvement in the future precisely because its per¬
formance is substandard.

These observations apply also to two intermediate factors—
the traffic density (ton-miles carried per mile of road) and the
average length of haul per ton. These figures relate to the
character of the traffic, but their influence shows itself largely
in the operating ratio.

The Specific Security .—As long as a road seems certain to
remain solvent with ample margins to spare, all its obligations
may be viewed almost as a unit, and the difference in value
between one fixed-value security and another is relatively minor.
With the first threat of trouble this difference begins to take on
great significance. Attention is then directed (1) to the character
of the mileage securing the bond and (2) to the order of its lien
thereon. The necessity of careful study, in such cases, of the
specific position of socalled “underlying bonds” and “divisional
liens” was emphasized at the end of Chap. VI. In studies of
this kind the “Freight Traffic Density Charts” 1 will prove of
great value, though it must be pointed out that these are not
readily accessible to ordinary analysts. Insolvent roads are
frequently required to segregate the earnings and expenses
applicable to the various mortgage liens, to determine the con¬
tribution of each issue to the earning power of the system.
Such data are usually made the basis of the treatment to be
accorded these issues in the reorganization plan. 2

1 See footnote p. 158.

*For segregations of this kind see the figures relating to the various
mortgage liens of Chicago and North Western for the year 1937. That
road’s first reorganization plan (dated 1936) based its treatment of the
different issues on their relative prices in a preceding period, but this was
superseded by the more accurate determination of relative value. Similar
data were made the basis of the treatment of the bonds of Chicago, Rock
Island and Pacific, as explained in its reorganization plan, dated July 15,
1936. Note, however, the special treatment sought to be accorded St. Paul
and Kansas City Short Line 4J^s, for reasons other than operating results.

FIXED-VALVE INVESTMENTS

169

In Appendix Note 66, p. 807, we present an analysis of
certain securities of Chicago, Milwaukee, St. Paul and Pacific
Railway as of December 31, 1939, to illustrate the technique of
security analysis as applied .to speculative railroad bonds.
The reader’s attention is directed also to the three much older
railroad analyses reproduced in the same Note. It may be
added that these analyses, and the entire preceding discussion, are
equally applicable to railroad stocks as well as speculative bonds.

PUBLIC-UTILITY BOND ANALYSIS

The popularity of public-utility securities between 1926 and
1929 resulted in an enormous increase in the amount of such
financing, but this increased quantity was accompanied by a
definite retrogression in the standards of quality and in the
methods of presentation employed by the issuing houses. Invest¬
ment bankers, including some of the highest reputation, followed
entirely indefensible practices in their offering circulars, in order
to make the issues appear safer than they actually were. Of
these objectionable devices, the most important were: (1) the
application of the term “public utility” to industrial operations;
(2) the use of the prior-deductions method of stating the earnings
coverage; and (3) the ignoring of depreciation in calculating the
net earnings available for bond interest.

1. Abuse of the Term “Public Utility.”—Just what constitutes
a public-utility enterprise may be the subject of some con¬
troversy. In its strict definition it would be any enterprise
supplying an essential service to the public, subject to the terms
of a franchise and to continuous regulation by the state. (While
steam railroads are in fact a public-utility undertaking, it is
convenient and customary to place them in a separate category.)
From the investment standpoint, the most important idea
associated with a public utility is that of stability , based first
upon the rendering of an indispensable (and generally exclusive)
service to a large number of customers, and, secondly, upon the
legal right to charge a rate of compensation sufficient to yield a
fair return on the invested capital.

It must be borne in mind that this stability is relative rather
than absolute, since it is not immune from basic changes or
unexpected vicissitudes. Twenty years ago the leading type
of utility was the street railway; but this industry is now subject

170

SECURITY ANALYSIS

to such severe competition from other forms of local transporta¬
tion that in most communities it is not practicable to set the fare
high enough to return reasonable earnings on the actual invest¬
ment. Furthermore, during the war inflation period of 1918-
1920 the light and power companies suffered keenly from rising
labor and material costs together with difficulties and delays
in obtaining permission to advance rates proportionately.
These hardships had for a time an adverse effect upon the
popularity of all utility investments, but the subsequent brilliant
expansion of both gross and net earnings of gas, electric, water
and telephone companies speedily restored their securities to
favor.

It is to three of these services, viz., gas, electric and telephone,
that the utility investments of savings banks are restricted by
the New York statute. We have remarked previously (page 109)
that this category may properly be widened to include companies
supplying water to communities of substantial size.

Pseudo-utilities .—But in the heyday of public-utility-bond
flotations, this popular label was used by banking houses to
promote the sale of many issues which partook only partially at
best of the true character of public utilities and which may well
be stigmatized as “pseudo-utilities.” Companies selling ice,
operating taxicabs or owning cold-storage plants became sud¬
denly “affected with a public interest” to an extent permitting
them to bond themselves for the major portion of their property
investment and to sell these bonds to investors as public-utility
securities. In most instances the enterprises so financed repre¬
sented a combination of small gas, electric or telephone estab¬
lishments with the ice or cold-storage businesss, in such a way as
to confuse or mislead the public as to the true nature of the
investment offered. An outstanding and unfortunate precedent
for this hybrid form of organization was set many years ago by
the Cities Service Company, which combined a large bona fide
public-utility network with an equally large venture in the pro¬
duction, refining, and marketing of oil.

Natural Gas .—The period preceding the 1929 crash was
marked also by the sudden transmutation of natural gas from a
branch of the oil industry into “one of the country's leading pub¬
lic utilities.” Up to that time, natural gas had been used mainly
as industrial fuel and as raw material for the production of gaso-

FIXED-VALUE INVESTMENTS

171

lines and carbon black. Improvements in pipe-line construction
permitted the transport of this gas over long distances to urban
centers where it replaced considerable quantities of manu¬
factured gas. Promoters and* banking houses were quick to
exploit the popular appeal of this new “utility”; and by the use
of this designation an enormous total of natural-gas bond financ¬
ing was successfully foisted on the public. As in the case of the
ice plants, considerable recourse was had to the device of com¬
bining a natural-gas development with small bona fide utility
properties. In many cases, the sale of these bonds under the
guise of public-utility investments was a gross abuse of the
public confidence, because the bulk of the natural-gas output
was being taken for manufacturing use and the business was
subject to all the hazards of the fuel industry. 1

The above exposition should make it plain that there are
utilities and “utilities,” and that investors must not take stability
for granted because an issue is marketed under this popular
title. In particular they should shun these hybrid mixtures of
electric or telephone services with industrial activities, because
at bottom every such combination represents an attempt to
sail under false colors. 2

2. Use of the Prior-deductions Method of Calculating Cover¬
age. —We have already indicated (pages 126-127) the fallacy
involved in the calculation of interest coverage after the deduc¬
tion of prior charges. This deceptive method seems now to have
been abandoned, but the investor should be on his guard against
its return. Furthermore, as we point out in Chap. XV, the
practice, still continued, of stating earnings on investment
preferred stocks as so many dollars per share, without reference to
prior-interest charges, is in essence identical with the prior-
deductions method of stating interest coverage.

3. Omission of Depreciation Charges in Calculating Coverage.
No satisfactory reason can be advanced for the formerly
widespread failure of the bond-offering circulars to deduct the
depreciation allowance before computing the interest coverage.
Depreciation is a real and vital element in the operating expense

1 Hamilton Gas Company was an example of a business almost entirely
industrial in character but financed on a public-utility basis. Result:
bankruptcy and an appalling shrinkage in security values.

s See Appendix Note 25, p. 752, for examples.

172

SECURITY ANALYSIS

of a public utility. In the case of the typical well-established
company, a good part of the annual-depreciation reserve is
actually expended for the renewal of worn-out or obsolete equip¬
ment, so that it cannot be claimed that depreciation is a mere
bookkeeping concept which need not be taken seriously. There
is naturally room for a divergence of opinion with respect to the
proper amount of depreciation to charge in any situation; but if
proper attention were given to the extremely important element
of obsolescence, it is hardly likely that the allowance made by
the typical holding company will be found excessive, and in
fact it is more likely to understate the true depreciation. 1

In the writers’ opinion, the cavalier omission of depreciation
charges in the statement of earnings applicable to bond interest
comes perilously close to outright misrepresentation of the facts. 2
A device fully as misleading is illustrated by the offering in 1924
of Cities Service Power and Light Company 6s, due in 1944.
In this case, the indenture was so drawn as to require a minimum
charge for depreciation and maintenance amounting to much
less than the sums actually expended and reserved by the various
operating subsidiaries. In the bond prospectus the earnings
were stated after deductions for depreciation “ assumed at rates
in the Indenture securing these bonds,” which in plain language
meant that the true depreciation was greatly understated in
calculating the margin of safety behind the bond issue. 3 This
piece of financing is commented on further below.

1 See the pungent comments on this head by William Z. Ripley, Main
Street and Wall Street , pp. 172-175 and 333-336, especially the latter, Boston,
1927. See also Chap. XXXV of the text for a further discussion of utility
depreciation charges.

2 This pernicious practice is encouraged, however, by the loosely drawn
provisions governing investments by saving banks in public-utility bonds
in various states, which apply the earnings test before deducting deprecia¬
tion. In Vermont, for example, depreciation is deducted in determining
the net income of telephone companies, but not in the case of gas, electric,
water, and traction companies. See Appendix Note 26, p. 7o2, for comments
by various committees of the Investment Bankers Association of America
with respect to the manner of handling depreciation charges in bond
circulars.

2 This company and others, once using the indenture basis of charging
depreciation in their bond-offering circulars and even their annual reports,
have nearly all given up that objectionable policy. However, the prospectus
of Alabama Gas Company, dated Sept. 15, 1936, calculates the provision for
retirements on the indenture basis.

FIXED-VALUE INVESTMENTS

173

Recommended Procedure.—It is emphatically recommended
that the intending purchaser of a public-utility bond issue make
sure that a normal depreciation charge has been deducted from
earnings, before he accepts the reported statement of interest
coverage. Based upon the reports of many such companies,
it would seem that an allowance amounting to less than 10% of
gross may be viewed with suspicion as probably inadequate.
In fact, the conservatively minded might be justified in applying
a minimum figure of 12% of gross. Depreciation actually
accrues, of course, as a percentage of the property account and
not of the revenues. But since there is a fairly constant rela¬
tionship between the investment and the gross receipts (about $4
of property for $1 of revenue) the adequacy of the depreciation
allowance may be conveniently judged by reference to the gross
revenues.

Examples Showing Need for Critical Examination of Offering
Circular .—The following actual example illustrates in rather
extreme fashion the practices formerly followed in bankers'
circulars offering public-utility bonds.

Utilities Service Company Convertible Debenture 6Hs,
due 1938, offered in 1928 at 99)^, yielding 6.55%. The presenta¬
tion in the offering circular may be summarized as follows:

Amount of issue... .$3,000,000

Business .Operates 20 telephone companies and 4 ice companies.

Value of property. .$12,500,000 after depreciation, equal to $1,650 per
$1,000 bond after deducting prior obligations.

Earnings

Gross.

Net before depreciation

Prior deductions.

Balance for debentures .
Interest on debentures .

Balance for stock.

“Balance as above is equal to 2.’

Year Ended
May 31, 1928
. . $3,361,000
969,000

. 441,000

. 528,000

. 195,000

. 333,000

times interest on this issue.”

Criticism of This Offering Circular. —1. The business is a
combination of utility (telephone) and industrial (ice) operations,
but it is bonded more heavily than a 100% utility enterprise
could safely stand, the total debt being 84% of the appraised
property value. The proportion of gross and net contributed

174

SECURITY ANALYSIS

by the ice business is not stated and must therefore be assumed
to be substantial. 1

2. The omission of the depreciation charge from the earnings
statement is so misleading as to appear almost fraudulent.
Depreciation reserves by telephone companies absorb a large
percentage of gross receipts. In the case of the American Tele¬
phone and Telegraph System this percentage averages about
15 % 2 , and the same deduction was actually made by the chief
subsidiary of the Utilities Service Company (Lima Telephone
Company). If depreciation at the rate of 15% of gross is charged
against the total revenue, the amount so to be deducted would
be $500,000, and would leave 'practically no earnings available for
the debenture interest. In other words, instead of covering the
debenture interest 2.71 times as stated, the company would be
failing to earn the interest charges by a large deficit.

The ice operations would carry a smaller depreciation charge
than 15% of gross, but this advantage should be offset by the
greater margin of safety required for an industrial business.
Furthermore, if the net valuation of $12,500,000 placed on the
property is accepted, then in any event the annual depreciation
deduction should not be less than 4% or $500,000.

3. The calculation of interest coverage in the circular made by
the prior-deductions method would indicate that the debentures
were better protected than the prior liens. (They ‘‘ earned their
interest” 2.71 times, while senior interest was covered 2.20 times.)

Assuming a low depreciation charge of $300,000 per annum, and
presenting the interest deductions properly, the exhibit of this
bond offering should be restated as follows:

Gross. $3,361,000

Net before depreciation. 969,000

Depreciation (estimated).. 300,000

Balance for interest. 669,000

Total interest charges. 636,000

Balance for d i vidends. 33,000

Interest charges earned. 1.05 times

1 Figures subsequently published show that the ice business made up more
than half of the total business.

2 There is some evidence (in court decisions and the 1939 report of the
Federal Communications Commission) that the depreciation charges of
American Telephone and Telegraph have been overliberal, but this would
hardly affect our reasoning as above.

FIXED-VALUE INVESTMENTS

175

4. The statement that there was $1,650 of property value
behind each $1,000 debenture is based upon a similarly mislead¬
ing method. The aggregate bonded debt was $10,500,000
against $12,500,000 of appraised value, so that the appraisal
showed only $1,190 of value behind each $1,000 of total debt. 1

Another example: It may be illuminating also to make a similar
critical examination of the advertisement offering Cities Service
Power and Light Company Secured 6s, due 1944, at 96 to yield
6.35%, as published in April 1926. The earnings data covering
the calendar year 1925 were presented substantially as follows:

Gross, including other income. $49,6G2,000

Net after operating expenses and taxes. 19,096,000

Deduct:

Fixed charges and preferred dividends of

subsidiaries. 10,102,000

Depreciation (“assumed at rates in the inden¬
ture securing these bonds'’). 1,574,000

Minority interest,. 209,000

Income applicable to interest of Cities Service

Power and Light. 7,211,000

Interest on this issue. 1,466,000

“ Income applicable to interest charges, as shown above, was
over 4.9 times maximum annual interest requirements on Series
A bonds of $1,466,250, and over 4.1 times maximum annual
interest charges of $1,736,250 on all outstanding funded debt
of Cities Service Power and Light Company.”

This circular was misleading in two important respects: first
in employing the prior-deductions method for computing the
earnings coverage on the bonds offered; and secondly, in using an
artificial and quite inadequate basis of depreciation. A study of
the application to list this issue on the New York Stock Exchange
shows that the operating subsidiaries actually made appropria¬
tions for replacements amounting to $5,214,000 for the year
ending June 30, 1925. This was almost four times the arbitrary
rates set up in the indenture. A revision of the offering circular,
to conform with the actual situation in respect to depreciation,
and with the proper method of stating interest coverage, will
show the following exhibit:

1 In 1932 the Utilities Service Company went into receivership and the
debenture bondholders lost their entire investment.

176

SECURITY ANALYSIS

Gross. $49,662,000

Net, after minority interest. 18,887,000

Depreciation for year ending Juno 30, 1925.... 5,214,000

Balance for fixed charges. 13,673,000

Interest and preferred dividends of subsidiaries. 10,102,000

Interest charges of parent company. 1,736,000

Total fixed charges. 11,838,000

Balance for parent company dividends. 1,835,000

Fixed charges earned. 1.16 times

This showing is very different indeed from a coverage of 4.1
or 4.9 times interest as indicated in the offering circular.

Deduction of Federal Taxes in Computing Interest Coverage.—
The federal income tax is imposed upon profits after subtracting
interest paid. Hence earnings available for interest should
properly be shown before deducting the federal tax. In corporate
reports to stockholders it is customary to reverse this order, and
in many cases the amount of the tax is not shown. But in
analyzing the exhibit of a bond issue, it should not be necessary
to revise the income statements by adding back the federal taxes,
actual or estimated. The reason is that the result produced by
such revision can very rarely make enough difference to affect the
apparent eligibility of the bond issue for investment. Further¬
more, the error, such as it is, lies on the side of understatement—
which is by no means objectionable in the selection of investment
bonds. In general, the analyst should refrain from elaborate
computations or adjustments which are not needed to arrive at
the conclusion he is seeking.

In bond-offering circulars, the income available for interest
is usually stated before deduction of federal tax, in order to make
the best showing permissible. This cannot properly be objected
to, except sometimes in the case of offerings of bond issues of
public-utility holding companies. Such bonds are usually
junior to the preferred stocks of subsidiary companies, and the
federal tax must be computed and deducted before these divi¬
dends are paid. Hence, objection may fairly be leveled against
a presentation such as was made in the offering circular of Cities
Service Power and Light Debenture 5Ks in November 1927,
wherein the earnings applicable for interest on the holding
company’s bonds were stated before deducting federal taxes of
the system.

CHAPTER XIII

OTHER SPECIAL FACTORS IN BOND ANALYSIS

“Parent Company Only” vs. Consolidated Return. —Both
bond-offering circulars and annual reports almost invariably
present the earnings statement of a public-utility holding-com¬
pany system in a consolidated form, i.e., they start with the gross
revenues of the operating subsidiaries and carry the figures down
through operating expenses, depreciation, fixed charges, and
preferred dividends of subsidiaries, until they arrive at the
balance available for the parent company's interest charges,
and finally at the amount earned on its common stock. There
is also published, largely as a matter of form, the income account
of the parent company only, which starts with the dividends
received by it from the operating subsidiaries and therefore does
not show the latter's interest and preferred dividend payments
to the public. The interest coverage shown by the income
account of the parent company only is an example of the prior-
deductions method, and consequently it will almost always
make a better showing for the parent company's bonds than will
be found in the consolidated report. The investor should pay
no attention to the “parent company only” figures and insist
upon a completely consolidated income account.

Example: The following example will illustrate this point:

Standard Gas and Electric System, 1931

Item

‘‘Parent com¬
pany only”

Consolidated

results

Gross revenues.

810,790,000

$159,070,000

Balance for fixed charges.

16,514,000

57,190,000

Fixed charges.

4,739,000

42,226,000

Balance for parent-company
stocks.

11,775,000

14,964,000

Fixed charges earned.

3.48 times

1.36 times

177

178

SECURITY ANALYSIS

The parent company did not receive in dividends the full
amount earned by its subsidiaries, but even with this smaller
income the prior-deductions method results in a much larger
indicated coverage for the parent-company bond interest on the
basis of its own results than on a consolidated basis.

Dividends on Preferred Stocks of Subsidiaries.—In a holding-
company system the preferred stocks of the important operating
subsidiaries are in effect senior to the parent company’s bonds,
since interest on the latter is met chiefly out of dividends paid on
the subsidiaries’ common stocks. For this reason subsidiary
preferred dividends are always included in the fixed charges of a
public-utility holding-company system. In other words, these
fixed charges consist of the following items, in order of seniority:

1. Subsidiaries’ bond interest.

2. Subsidiaries’ preferred dividenas.

3. Parent company’s bond interest.

This statement assumes that all the subsidiary companies are
of substantially the same relative importance to the system.
An individual subsidiary which happens to be unprofitable may
discontinue preferred dividends and even bond interest, while at
the same time the earnings of the other subsidiaries may permit
the parent company to continue its own interest and dividend
payments. In such a case, which is somewhat exceptional, the
unprofitable subsidiary’s charges are not really senior to the
parent company’s securities. This point is discussed at the end
of Chap. XVII.

The fixed charges should also properly include any annual
rentals paid for leased property which are equivalent to bond
interest or guaranteed dividends. In the majority of holding-
company reports this practice is followed (e.g., Public Service
Corporation of New Jersey).

The holder of preferred shares of an important operating
subsidiary has to all intents and purposes a claim which is as
fixed and enforceable on the system’s earnings as have the owners
of the parent company’s bonds. But if the parent company
becomes insolvent, then the owners of the underlying preferred
issues no longer occupy the strategic position of bondholder,
since they cannot compel the operating subsidiary to continue
paying its preferred dividends.

FIXED-VALUE INVESTMENTS

179

Example : New York Water Service Corporation Preferred may
be cited as an example. The company is an operating subsidiary
of Federal Water Service Corporation, which in turn was a sub¬
sidiary of Tri-Utilities Corporation. Dividends on this issue
and on Federal Water Service Preferred ranked as fixed charges
of the Tri-Utilities system. When the latter company was
unable to meet interest on its debentures and went into receiver¬
ship in August, 1931, dividends on these underlying preferred
issues were promptly discontinued, although both were appar¬
ently earned and the income of New York Water Service Corpora¬
tion actually showed an increase over the previous year.

Minority Interest in Common Stock of Subsidiaries.—The
earnings applicable to minority stock are usually deducted in
the income statement after the parent company’s bond interest,
and hence the former item does not reduce the margin of safety
as generally computed. We prefer to subtract the minority
interest before calculating the interest coverage. Exact treat¬
ment would require a prorating of deductions, but this involves
needlessly burdensome calculations. When the minority interest
is small, as is true in most cases, the difference between the
various methods is inconsequential. When the minority interest
is fairly large, analysis will show that the customary procedure
gives a margin of safety somewhat higher than is strictly accurate,
whereas our method errs moderately in the opposite direction,
and hence should be preferred by conservative investors. 1

“Capitalization of Fixed Charges,” for Railroads and Utilities.
In the previous chapter we pointed out certain difficulties in the
way of arriving at a fair statement of the ratio of stock to debt
in the case of railroads and public utilities. Debt may be repre¬
sented not only by bond issues but also by guaranteed stocks,
annual rental obligations, and effectively also by nonguaranteed
preferred stocks of operating subsidiaries. In computing the
interest coverage these items are taken care of by using the
omnibus figure of fixed charges, instead of merely the bond
interest. The principal amount of all these obligations is
usually stated quite clearly in the consolidated balance sheet of a
public-utility enterprise; but this may not be true in the case of

1 See Appendix, Note 27, p. 753, for a calculation under the three methods
applied to the report of United Light and Railways Company for 1938.

180

SECURITY ANALYSIS

a railroad company, chiefly because its rental obligations are
not likely to be reflected in the balance sheet.

We suggest, therefore, that the “true” or “effective” debt of a
railroad may be calculated by multiplying the fixed charges by an
appropriate figure, say 22. This is equivalent to capitalizing
the fixed charges at an assumed rate of 4^%—in other words,
to assuming that the true debt is that figure, 4 X A% on which
will produce the annual fixed charges. (The 4 x /i % figure reflects
the actual current interest rate carried by railroad indebtedness
as a whole in 1938.) 1

Technique Illustrated .—We have suggested that the earnings
coverage for railroads be applied to either the Net Deductions
or the Fixed Charges (as previously defined), whichever are
larger. In the same way the larger of these two items should be
used as the base for computing the principal amount of the road’s
“effective debt.” The technique to be followed is illustrated
herewith:

Examples:

New York, New Haven and Hartford Railroad

A. Net deductions (1932). $ 18,511,000

B. Fixed charges (1932). 17,403,000

Net deductions capitalized at 4H%. $408,000,000

(Funded debt shown on balance sheet—$258,000,000)
Preferred stock: 490,000 sh. @50 (July 1933). . $ 24,500,000
Common stock: 1,570,000 sh. @22 (July 1933) 34,500,000

Total market value of stock issues. $ 59,000,000

Stock-to-bond ratio—1 to 6-9

Net deductions earned, 1932. .. 0.93 times

Net deductions earned, 7-yr. average. 1.57 times

Chesapeake and Ohio Railway

A. Net deductions (1932). $ 9,870,000

B. Fixed charges (1932).:. 10,760,000

Fixed charges, capitalized at 4H %. $239,000,000

Bonded debt shown on balance sheet . 222,000,000

Common stock: 7,650,000 sh. @ 38 (July 1933) 291,000,000
Stock-to-bond ratio—1 to .82 (t.e., $1 of stock to 82 cents of

bonds)

Fixed charges earned, 1932. 3.21 times

Fixed charges earned, 7-yr. average.3.80 times

1 In the few instances in which a public utility shows rental payments not
reflected in the balance sheet, it would be sufficient to capitalize such a
rental at, say, 4J^ % and add this value to the senior security total.

FIXED-VALUE INVESTMENTS

181

Conclusions Based on Foregoing .—The 1 ‘effective debt” of the
New Haven was computed from the net deductions (which are
larger than the fixed charges, because they include a substantial
debit for equipment rentals, etc.). This effective debt is con¬
siderably more than that shown in the balance sheet. With the
preferred and common stocks together selling in July 1933 for less
than a sixth of the true debt, it is evident that the bonds had an
insufficient stock equity at the time. If the 'prospects were
considered favorable there might be good reason to buy the
common stock for larger capital application. But no such
possibility attached to the 6% bonds selling at 92, and conse¬
quently the purchase of this issue could not be supported by
sound analysis.

The Chesapeake and Ohio exhibit, on the other hand, supplies
a stock-value ratio which fully confirms the satisfactory showing
of the earnings coverage. If the investor were satisfied with
the prospects of this road, he would then be justified in buying
its bonds ( e.g. } the Refunding and Improvement 4^s selling at
92^) since these meet both quantitative tests in satisfactory
fashion.

THE WORKING-CAPITAL FACTOR IN THE ANALYSIS OF
INDUSTRIAL BONDS

For reasons already explained, a company’s statement of its
fixed assets will not ordinarily carry much weight in determining
the soundness of its bonds. But the current-asset position has
an important bearing upon the financial strength of nearly all
industrial enterprises, and consequently the intending bond
purchaser should give it close attention. It is true that industrial
bonds which meet the stringent tests already prescribed will in
nearly every instance be found to make a satisfactory working-
capital exhibit as well, but a separate check is nevertheless
desirable in order to guard against the exceptional case.

Current assets (termed also “liquid,” “quick,” or “working”
assets) include cash, marketable securities, receivables, and
merchandise inventory. 1 These items are either directly

l Some authorities exclude inventories from “quick assets,” but include
them in “current assets.” This distinction is useful, and we suggest that
it be adopted as standard. It has been followed in the S.E.C.-W.P.A.
“Census of American Listed Corporations,” a series of studies published in
1938-1940.

182

SECURITY ANALYSIS

equivalent to cash, or are expected to be turned into cash,
through sale or collection, in the ordinary course of business.
To conduct its operations effectively, an industrial enterprise
must possess a substantial excess of current assets over current
liabilities, the latter being all debts payable within a short term.
This excess is called the working capital, or the net current assets.

Three Requisites with Respect to Working Capital.—In
examining the current-asset situation, an industrial bond buyer
should satisfy himself on three counts, viz.:

1. That the cash holdings are ample.

2. That the ratio of current assets to current liabilities is a strong one.

3. That the working capital bears a suitable proportion to the funded
debt.

It is not feasible to fix definite minimum requirements for any
one of these three factors, especially since the normal working-
capital situation varies widely with different typos of enterprise.
It is generally held that current assets should be at least double
the current liabilities, and a smaller ratio would undoubtedly
call for further investigation. We suggest an additional standard
requirement for the ordinary industrial company, viz., that the
working capital be at least equal to the amount of the bonded
debt. This is admittedly an arbitrary criterion, and in some
cases it may prove unduly severe. But it is interesting to note
that in the case of every one of the industrial issues which
maintained their investment rank marketwise throughout 1932,
as listed on page 97, the working capital exceeded the total of
bonds. 1

In contrast with the emphasis laid upon the current-asset
position of industrial concerns, relatively little attention has been
paid to the working capital shown by railroads, and none at all
to that of public utilities. The reason for this is twofold.
Neither railways nor utilities have the problem of financing the

1 General Baking reached this position during 1932. Including General
Baking, 13 of the 18 companies showed cash assets alone exceeding their
funded debt. Certain types of industrials— e.g., baking, ice and restaurant
concerns—normally require a relatively small amount of working capital in
relation to total assets and business. For such businesses, the 100 % net
current-asset coverage requirement for bonds would be overstringent. See
our later discussion of indenture provisions requiring maintenance of
working capital as a protection for bond issues (Chap. XIX).

FIXED-VALUE INVESTMENTS

188

production and carrying of merchandise stocks or of extending
large credits to customers. Furthermore, these companies have
been accustomed to raising new capital periodically for expansion
purposes, in the course of which they readily replenish their
cash account if depleted. Because new financing is easily obtain¬
able by prosperous companies of this type, even an excess of
current liabilities over quick assets lias not been considered a
serious matter. Recent experience indicates the desirability
of substantial cash holdings by a railroad to meet emergency
developments, and the bond buyer might do well to favor those
public utilities also which maintain a comfortable working-capital
position.

CHAPTER XIV

THE THEORY OF PREFERRED STOCKS

That the typical preferred stock represents an unattractive
form of investment contract is hardly open to question. On the
one hand, its principal value and income return are both limited;
on the other hand, the owner has no fixed, enforceable claim to
payment of either principal or income. It may be said that
preferred stocks combine the limitations of creditorship (bonds)
with the hazards of partnership (common stocks). Yet despite
these strong theoretical objections, the preferred stock has
developed into a major factor in our financial scheme, and has
evidently succeeded in commending itself to the American
investor. In 1939 there were about 420 different preferred issues
listed on the New York Stock Exchange as against some 830
common stocks. In 1929 the value of the listed preferred shares
exceeded 8 x /i billion dollars and was about half as great-as that
of listed corporation bonds. 1

The Verdict of the Market Place. —In the subsequent market
collapse, the price of these shares suffered a drastic shrinkage,
an experience that was repeated on a smaller scale in 1937-1938.
The following comparative figures tell an interesting story:

Average of All Listed on the New York Stock Exchange

Type of security

High

price

1929

Low

price

1932

High

price

1937

Low

price

1938

Price
Dec. 30,
1939

United States corporate bonds. .

95.33

52.68

90.89

65.82

74.60

Preferred stocks.

84.99

25.38

75.15

46.50

61.55

Common stocks.

89.94

10.59

43.29

20.44

30.16

These figures establish the fact that, although both bonds and
preferred stocks have shown themselves vulnerable to adverse

1 At the end of 1939 the value of all listed preferred shares was about
$6,250,000,000, compared with about $14,250,000,000 for all listed cor¬
poration bonds (New York Stock Exchange totals).

1$4

FIXED-VALUE INVESTMENTS

185

conditions, there can be no doubt that preferred stocks as
a whole are subject to the greater percentage decline. Certainly
a contrast exists between the theoretical weakness plus the
unsatisfactory performance of.preferred stocks, on the one hand,
and their widespread popular acceptance, on the other. A
thoroughgoing analysis would seem to be called for, in order to
determine the true merits of preferred shares as a practical
medium of investment.

Basic Difference between Preferred Stocks and Bonds.—The

essential difference between preferred stocks and bonds is that
payment of preferred dividends is entirely discretionary with the
directors, whereas payment of bond interest is compulsory.
Preferred dividends must indeed be paid as long as any disburse¬
ments are being made on the common shares; but since directors
have the power to suspend common dividends at any time the
preferred stockholder’s right to income is at bottom an entirely
contingent one. However, if a company’s earnings are regularly
far in excess of preferred-dividend requirements, payment is
usually made as a matter of course; and in such instances, the
absence of an enforceable claim to dividends does not seem to
be of real importance. This explains the existence of a relatively
small number of high-grade preferred issues which are considered
equivalent in quality to sound bonds and sell at comparable
prices.

At the opposite extreme are the cases in which corporations
are unable to pay anything , whether it be on bonds or on pre¬
ferred stock. In such situations the bondholder’s legal right to
receive interest results not in payment but in bankruptcy. As
we have previously pointed out, the practical value of this
remedy is doubtful, and in most instances it may fairly be said
that the position of a bond in default is little better than that of
a nondividend-paying preferred stock without bonds ahead
of it.

At both extremes therefore, the contractual superiority of
bonds over preferred stocks is not of substantial value. This
fact has led many investors to believe that as a general rule the
bond form has no real advantage over the preferred stock form.
Their line of reasoning runs: “If the company is good, its pre¬
ferred stock is as good as a bond; and if the company is bad, its
bonds are as bad as a preferred stock.”

186

SECURITY ANALYSIS

Weakness Because of the Discretionary Right to Omit Divi¬
dends. —This point of view is highly inexact, because it fails to
take into account the wide middle region occupied by companies
neither unqualifiedly “good” nor unqualifiedly “bad,” but sub¬
ject to variations and uncertainties in either direction. If it
could be assumed that directors will always pay preferred divi¬
dends when possible (and hence will suspend payment only under
conditions which would compel default of interest if the issue
were a bond), then even in the intermediate situations the pre¬
ferred stockholder’s status would not be greatly inferior to the
bondholder’s. But in actual fact this is not the case, because
directors frequently exercise their discretion to withhold preferred
dividends when payment is by no means impossible but merely
inconvenient or inexpedient. It is considered an approved
financial policy to sacrifice the preferred stockholder’s present
income to what he is told is his future welfare; in other words,
to retain cash available for dividends in the treasury to meet
future emergencies or even for future expansion.

Even if it be conceded that such a practice may ultimately
be advantageous to the preferred stockholder, the fact remains
that it subjects his income to a hazard not present in the case of a
similarly situated bond. If such a hazard is at all substantial,
it automatically disqualifies the preferred issue as a fixed-value
investment, because it is the essence of such investments that
the income must be considered entirely dependable. Stating
the point more concretely, any preferred stock subject to a real
danger of dividend reduction or suspension will fluctuate widely
in market value. It is a point 'worth noting that in all cases
where the dividend could be continued, but instead is withheld
“for the sake of the stockholders’ future advantage,” the quoted
price suffers a severe decline, indicating that the investment
market does not agree with the directors as to what is really in
the best interests of the preferred stockholders.

Conflicts of Interest. —Nearly every investor would rather have
his income continued, even at possible risk to the future of the
business. There is evidently a basic disagreement, amounting
almost to a logical contradiction, between what the investor
considers to be his individual advantage (viz., the continuance
of his income at all costs) and what he seems willing to admit
may be sound corporate policy ( viz., the suspension of dividends

FIXED-VALUE INVESTMENTS

187

for the sake of the future). In this connection, the question of a
possible conflict of interest between the preferred and the com¬
mon stockholders is of undoubted importance. Withholding
preferred dividends may be of distinct advantage to the common
stock. The directors are legally required to represent the
interests of all stockholders impartially, but since in fact they
are most often elected by the common stockholders they
tend to act primarily in the latter’s behalf. Directors have also
grown accustomed to consider the interests of the enterprise
itself, as an entity apart from the interests of its owners— i.e.,
the stockholders—and they frequently pursue policies with the
apparent purpose and result of strengthening the corporation at
the actual expense of its proprietors. This paradoxical viewpoint
may perhaps be explained in part by the customary close connec¬
tion between corporate directors and the salary-drawing officers. 1

Form of Preferred Contract Often Entails Real Disadvantage.
Whatever the reason or justification may be, the fact remains
that preferred stockholders are subject to the danger of inter¬
ruption of dividend payments under conditions which would not
seriously threaten the payment of bond interest. This means
that the form of the preferred stockholder’s contract will often
entail a real disadvantage.

Example: A striking illustration of this fact is afforded by the
case of United States Steel Corporation Preferred, which is prob¬
ably the largest senior stock issue in the world, and was for
many years thoroughly representative of those preferred shares
which enjoyed a high investment rating. In 1931—although the
depression was well advanced—this issue sold at a price to yield
only 4.67%, and it was thought to occupy an impregnable posi¬
tion as a result of the accumulation of enormous sums out of the
earnings during the preceding 30 years and their application to
the improvement of manufacturing facilities, the enlargement of
working capital, and the retirement of nearly all the bonded debt.
Yet immediately thereafter, a single year of operating losses
jeopardized the preferred dividend to such an extent as to destroy
nearly two-thirds of its market price and undermine completely
its standing as a prime investment. In the following year the
dividend was reduced to $2 annually.

1 See our further discussion of this point in Chap. XLIV on Stockholder-
management Relationships.

188

SECURITY ANALYSIS

These disastrous developments were due, of course, to the
unprecedented losses of 1932-1933. But if it had not been for
the weakness of the preferred stock form } the holder of these
shares would have had little reason to fear the discontinuance of
his income. In other words, if he had possessed a fixed claim for
interest instead of a contingent claim for dividends, he could
have relied with confidence on the corporation’s enormous
resources to take care of its obligations. In support of this con¬
tention, a brief comparison is appended of the market action of
Inland Steel 4j^s (previously discussed) with that of United
States Steel Preferred.

Period

U.S. Steel Pfd.

Inland Steel 4^%
bonds, due 1978

Price

Yield, %

BS5I

Yield, %

High price, 1931.

150

4.62

Low price, 1932.

51 H

7.54

High price, Jan. 1933..

■

5.67

Both of these issues were subject to the same adverse business
conditions, but the contractual weakness of United States Steel
Preferred was responsible for the loss of an investment position
which the Inland bonds were able to retain without serious
difficulty (except for a brief period of utter demoralization in the
bond market).

Voting Rights a Potential Safeguard but Generally Ineffective.

The contractual weakness of preferred stocks as compared
with bonds might be greatly reduced if preferred stockholders
were to exercise effective voting control over the enterprise as soon
as either dividends or sinking-fund were suspended. We shall
point out in our later chapters on protective provisions that such
voting control, properly exercised, might constitute the best pro¬
tective and remedial arrangement for both bonds and preferred
stock. This would imply that, given suitable protective provisions
intelligently availed of , the practical position of bondholders and
preferred shareholders Would not be significantly different. In
our opinion, a good part of the present very real inferiority of
preferred stocks to bonds is ascribable to the failure of pre¬
ferred stockholders either to obtain voting control promptly or

FIXED-VALUE INVESTMENTS

189

to exercise it intelligently, after dividends are suspended.
However, our analysis of the investment status of preferred
stocks must be predicated on the undoubted fact that, with
conditions as they are, the individual holder of preferred shares
cannot rely upon his voting rights to achieve full protection of
his interests.

Yield and Risk. —Returning to the actual performance of
preferred issues in the last decade, their unsatisfactory record
as a class may well raise the question if they should not be com¬
pletely avoided as a medium of fixed-v due investment. But in
rebuttal it may be pointed out that a small number of preferred
issues maintained an investment rating even at the worst
moments of 1932, and a much larger number during the severe
recession of 1938. The proponents of preferred shares will
contend, moreover, that under normal variations in business
conditions the higher yield of this group will compensate for
such inferiority as exists in their safety as compared with bonds.
This is an argument which always appeals to the investor in good
times, when the increased income is an actuality and the risk to
principal seems a remote contingency. In bad times there is
perhaps an opposite disposition to consider only the shrinkage of
principal suffered and to forget about the higher income received
in the years preceding.

To present a broader view of this question, we revert to our
previous discussion of bonds with varying degrees of safety, in
which we arrived at the principle that risk and income return
are at bottom incommensurable . If this statement is valid for
bonds, it must apply w T ith equal force to preferred stocks. This
means that it is not sound procedure to purchase a preferred
stock at an investment price ( e.g ., close to par) when the presence
of a substantial risk to principal is recognized, but when this
risk is expected to be offset by an attractive dividend return.
It would follow from this principle that the only preferred stock
which can properly be bought for investment would be one
which in the purchaser’s opinion carries no appreciable risk of
dividend suspension.

Qualification of High-grade Preferred Stocks. —What must
be the qualifications of such a preferred stock? In the first
place, it must meet all the minimum requirements of a safe bond.
In the second place, it must exceed these minimum requirements

190

SECURITY ANALYSIS

by a certain added margin to offset the discretionary* feature in
the payment of dividends; i.e ., the margin of safety must be so
large that the directors may always be expected to declare the
dividend as a matter of course. Thirdly, the stipulation of
inherent stability in the business itself must be more stringent
than in the case of a bond investment, because a company
subject to alternations between large profits and temporary
losses is likely to suspend preferred dividends during the latter
periods even though its average earnings may far exceed the
annual requirements.

The foregoing reasoning suggests conclusions that correspond
to the actual behavior of preferred shares in 1932-1933. These
conclusions are, not that preferred stocks must, per se y be
excluded from the investment category, but rather that such
severe specific requirements must be imposed upon them as to
make the number of eligible issues comparatively small. The
list shown on page 191 comprises all of the preferred stocks listed
on the New York Stock Exchange which maintained a price
equal to a 7% return or less at all times during 1932 and 1933. 1
There are appended also, certain quantitative data bearing on
the degree of safety enjoyed by each of these issues.

Sound Preferred Issues Exceptional .—This list of preferred
stocks comprises only 5% of the total number of issues listed
on the New York Stock Exchange in 1932. This small per¬
centage bears out our thesis that a sound preferred stock, while
not an impossibility, is an exceptional phenomenon. It may be
called exceptional not only in the numerical sense, but also from
a more theoretical standpoint. In practically every instance in
the above list, the preferred stock could have been replaced by a
bond issue without affecting in any material degree the soundness
of the corporation’s capital structure. This means that the
company itself derived no important advantage through having
preferred stock outstanding instead of bonds, and on the other
hand it suffered important disadvantages through income-tax
liability and also because of the higher cost of its senior capital. 1

1 We exclude Standard Oil Export Corporation 5% Preferred; Pittsburgh,
Fort Wayne and Chicago Railway 7% Preferred and other guaranteed
preferred issues, since they occupy substantially the position of a debenture
bond of the guarantor.

* Bond interest is deductible from earnings before arriving at the profit
subject to income tax, but preferred dividends may not be so deducted.

Listed Preferred Stocks Which Maintained an Investment Price-level throughout 1932-1933

FIXED-VALUE INVESTMENTS

101

Ratio of
lowest mar¬
ket value of
common to
preferred and
bonds com¬
bined

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H • ■ •

Number of times preferred
dividends (and fixed
charges) were earned
1927-1931

Minimum

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Funded

debt

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low price,

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Name of company

General Electric (Par $ 10 ) (Cum.).

Eastman Kodak (Cum.).

Duquesne Light (Cum.).

Public Service Electric <k Gas (Cum.).

United States Tobacco (Non-cum.) .

Procter <k Gamble ( 2 d Preferred) (Cum.).

Norfolk <fc Western R.R. (Non-cum.).

G. W. Helme (Non-cum.).

American Tobacco (Cum.) .

Ingersoll-Rand (Cum.).

Standard Brands (Cum.).

Kansas City Power & Light (Cum.).

Oti 3 Elevator (Cu'n.) .

American Snuff (Non-cum.) .

National Biscuit (Cum.).

Consolidated Gas Co. of New York (Cum.).

Liggett & Myers (Cum.) .

Brown Shoe (Cum.) (Linking Fund).

Pacific Telephone & Telegraph (Cum.).

Corn Products Refining (Cum.).

Island Creek Coal (Par $ 1 ) (Cum.).

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192

SECURITY ANALYSIS

Stating the matter differently, in order that a preferred stock
may be thoroughly sound, the burden it imposes must be so
light that the company may just as readily carry that burden
in the form of a bond obligation.

We are led therefore, to the final conclusion that not only are
sound preferred stocks exceptional but in a certain sense they
must be called anomalies or mistakes, because they are preferred
issues which should really be outstanding as bonds. Hence the
preferred stock form lacks basic justification, from an investment
standpoint, in that it does not offer mutual advantages to both
the issuer and the owner. Wherever the issuing business derives
a real benefit from its discretionary right to suspend dividends,
then the owner does not possess a fixed-value investment. And
conversely, when the issue is a high-grade one, then the issuer
derives no such benefit.

High-grade Preferred Stocks Usually Seasoned Issues.—In

support of the above conclusion, it should be observed that high-
grade industrial preferred issues have almost always reached this
position as the result of many years of prosperous growth by
the corporation after the preferred stock was first created.
Exceedingly few preferred shares are so strongly entrenched at
the time of original sale as to meet the stringent requirements
needed for a full investment rating. For when a corporation
is able to make as strong a showing as we require, it will nearly
always prefer to do its financing through a relatively small
bond issue, at a low interest rate and with substantial income-
tax saving. This docs not apply to the public-utility companies
since, for reasons probably related to the “legal investment”
status of their bond issues, they prefer to carry a portion of their
senior financing in the form of stock. (Thus, four of the five
high-grade utility preferred stocks included in the above list
were floated in recent years.) But the industrial preferred shares
in this list present an entirely different picture. Only one out of
the 15 issues was actually sold to the public within the past
20 years, and even this exception (Procter and Gamble Company
5% Preferred) was floated to replace an older preferred issue at a
lower dividend rate. The General Electric Company senior
shares were the result of a stock-dividend plan, but the 13 other
issues originated long ago and owe their investment status to the
prosperous years which followed.

FIXED-VALUE INVESTMENTS

193

Preferred-stock Financing 1935-1938.—Our view that the
preferred stock form lacks inherent logic must be advanced
with the caveat that it is not shared by investment bankers.
New financing in recent years has included a sizable number of
preferred-stock offerings. Many of these have been privileged
issues (convertibles, etc.) and as such fall outside the present
discussion. But there have also been flotations of straight
industrial preferreds—at least eight such new issues having been
listed on the New York Stock Exchange between 1935 and 1938. 1
All but one of these would have met our stringent tests of
safety, and hence they could not be objected to as insecure.
But in our opinion they might just as well, or better, have been
floated as bonds.

Origin of the Popularity of Preferred Stocks.—At the beginning
of this discussion, we referred to the prominent role that preferred
stocks have played in financing American corporations. But
if our subsequent analysis is correct in concluding that this form
of straight investment is fundamentally unsound, it may be
asked why this unsoundness was not long ago convincingly
demonstrated by the actual experience of investors. The
answer is that the great popularity of preferred stocks developed
during a 15-year period which rather accidentally favored the
typical preferred stockholder against the typical bondholder.
At the beginning of this period, just before the World War, the
majority of preferred stocks were industrial issues and most of
these were admittedly speculative in character, selling at sub¬
stantial discounts from par. The tremendous prosperity and
growth of our larger enterprises during the war, and during the
years subsequent to 1922, effected a great improvement in the
status and hence in the market price of many of the leading
industrial preferred stocks. Within the same time, railroad and
traction obligations, which constituted the main portion of the
bond list , were subjected to influences of a generally adverse
character. Investors, observing that the typical preferred stock
was behaving better than the typical bond, drew the natural
but erroneous inference that preferred stocks in general were
intrinsically as sound as bonds.

1 These were issued by Champion Paper and Fibre, Continental Can,
Du Pont, General Foods, Loose-Wiles Biscuit, Monsanto Chemical, G. C.
Murphy, Scott Paper.

194

SECURITY ANALYSIS

Poor Record Shown by Extensive Study of Preferred Issues.

More detailed investigation will show that the popularity of
preferred stocks rested upon the excellent performance of a
comparatively small number of old-established, and prominent
industrial issues. During the latter part of the period under
review, the much more numerous new flotations of industrial
preferred stocks, sold on the strength of this very popularity,
did not fare so well. A study was made under the direction of
the Harvard School of Business Administration, covering all the
new preferred-stock offerings from January 1, 1915 to January 1,
1920 which ranked between $100,000 and $25,000,000 in size
(607 issues in all). This showed that the average price of 537
issues for which quotations w’ere obtainable on January 1, 1923,
had declined to a figure 28.8% below the original offering price
(from 99 to 703^), so that their purchasers had suffered a shrink¬
age in principal greater than the total income received. The
conclusions drawn from this inductive study were highly unfavor¬
able to preferred stocks as a form of straight investment. 1

A More Recent Study.—A more recent investigation published
by the Bureau of Business Research of the University of Michigan
leads its author to a quite different opinion. 2 His “tests" of
preferred stocks preceded by bond issues (both railroad and
industrial) indicate clearly that senior shares of this type do not
offer a satisfactory medium of investment. But with respect
to industrial preferred stocks not preceded by bonds , the author's
tests bring him to the opposite conclusion. Of these, he asserts
that “they appear to meet the most exacting investment tests"
and also that diversified investment in such issues would seem to
“provide both a degree of safety for principal and an income
return greater than that achieved by industrial or railroad
bonds."

1 Quotations were not obtainable, even from the issuing houses, for 70 out
of 607 issues. Hence the loss to the investor was undoubtedly greater than
that indicated by the 537 cases studied statistically. For further details
of this study see: Arthur S. Dewing, “The Role of Economic Profits in the
Return on Investments,” Harvard Business Review , Vol. I, pp. 451, 461-462;
Arthur S. Dewing, Financial Policy of Corporations , Book vi, Chap. 2, pp.
1198-1199, New York, 1926.

a Rodkey, Robert G., Preferred Stocks as Long-term Investments , Ann
Arbor, University of Michigan Press, 1932.

FIXED-VALVE INVESTMENTS

19S

The deduction that it is better to buy preferred stocks without
rather than with bonds ahead of them is undoubtedly sound,
since the latter group is clearly more vulnerable to adverse
developments. But in our view the methods followed in this
investigation are open to certain objections that greatly diminish
the practical value of its other conclusions. 1 One feature of the
study, however, deserves particular comment. The detailed
figures show in striking fashion that the stability of nearly every
preferred stock considered was directly dependent upon an
increase in the value of the common stock. The preferred stock¬
holder had a satisfactory investment only while the common
stock was proving a profitable speculation. As soon as any
common stock declined in market value below the original price,
the preferred shares did likewise.

An investment subject to such conditions is clearly unwise.
It is a case of: “Heads, the common stockholder wins; tails,
the preferred stockholder loses.” One of the basic principles
of investment is that the safety of a security with limited return
must never rest primarily upon the future expansion of profits.
If the investor is positive that this expansion will take place, he
should obviously buy the common stock and participate in its
profits. If, as must usually be the case, he cannot be so certain
of future prosperity, then he should not expose his capital to a
risk of loss (by buying the preferred stock) without compensating
opportunities for enhancement.

1 For a brief statement of Dr. Rodkey’s approach and of the objections
thereto see the 1934 edition of this work, Appendix Note 25.

CHAPTER XV

TECHNIQUE OF SELECTING PREFERRED STOCKS
FOR INVESTMENT

Our discussion of the theory of preferred stocks led to the
practical conclusion that an investment preferred issue must
meet all the requirements of a good bond, with an extra margin
of safety to offset its contractual disadvantages. In analyzing
a senior stock issue, therefore, the same tests should be applied
as we have previously suggested and described with respect to
bonds.

More Stringent Requirements Suggested. —In order to make
the quantitative tests more stringent, some increase is needed in
the minimum earnings coverage above that prescribed for the
various bond groups. The criteria we propose are as follows:

Minimum Average-earnings Coverage

Class of enterprise

For investment
bonds

For investment
preferred stocks

Public Utilities.

Railroads.

1% times fixed charges

2 times fixed charges

3 times fixed charges

2 times fixed charges
plus preferred dividends
2 % times fixed charges
plus preferred dividends
4 times fixed charges
plus preferred dividends

Industrials.

These increases in the earnings coverage suggest that a cor¬
responding advance should be made in the stock-value ratio.
It may be argued that since this is a secondary test it is hardly
necessary to change the figure. But consistency of treatment
would require that the minimum stock-value coverage be raised
in some such manner as shown in the table on page 197.

The margins of safety above suggested are materially higher
than those hitherto accepted as adequate, and it may be objected
that we are imposing requirements of unreasonable and prohibi-

196

FIXED-VALUE INVESTMENTS

197

Class of enterprise

Minimum current stock-value ratio

For investment bonds

For investment pre¬
ferred stocks

Public utilities.

$2 bonds to SI stock

$ 13 ^ bonds to $1 stock

$1 bonds to $1 stociv

$1K bonds and pre¬
ferred to SI junior
stock

$1 bonds and preferred
to SI junior stock
$1 bonds and preferred
to Sl^ junior stock

Railroads.

Industrials.

tivc stringency. It is true that these requirements would have
disqualified a large part of the preferred-stock financing done in
the years prior to 1931, but such severity would have been of
benefit to the investing public. A general stabilization of busi¬
ness and financial conditions may later justify a more lenient
attitude towards the minimum earnings coverage, but until
such stabilization has actually been discernible over a consider¬
able period of time the attitude of investors towards preferred
stocks must remain extremely critical and exacting.

Referring to the list of preferred stocks given on page 191, it
will be noted that in the case of all the industrial issues the stock-
value ratio at its lowest exceeded 1.6 to 1, and also that the
average earnings coverage exceeded 5.6 times. 1

Mere Presence of Funded Debt Does Not Disqualify Preferred
Stocks for Investment.—It is proper to consider whether an
investment rating should be confined to preferred stocks not
preceded by bonds. That the absence of funded debt is a desir¬
able feature for a preferred issue goes without saying; it is an
advantage similar to that of having a first mortgage on a property
instead of a second mortgage. It is not surprising, therefore,
that preferred stocks without bonds ahead of them have as a
class made a better showing than those of companies with funded
debt. But from this rather obvious fact it does not follow that
all preferred stocks with bonds preceding arc unsound invest¬
ments, any more than it can be said that all second-mortgage
bonds are inferior in quality to all first-mortgage bonds. Such
a principle would entail the rejection of all public-utility preferred

1 We do not consider it necessary to suggest an increase in minimum size
above the figures recommended for investment bonds.

198

SECURITY ANALYSIS

stocks (since they invariably have bonds ahead of them) although
these are better regarded as a group than are the “nonbonded”
industrial preferreds. Furthermore, in the extreme test of 1932,
a substantial percentage of the preferred issues which held up
were preceded by funded debt. 1

To condemn a powerfully entrenched security such as General
Electric preferred in 1933 because it had an infinitesimal bond
issue ahead of it, would have been the height of absurdity. This
example should illustrate forcibly the inherent unwisdom of
subjecting investment selection to hard and fast rules of a
qualitative character. In our view, the presence of bonds senior
to a preferred stock is a fact which the investor must take care¬
fully into account, impelling him to greater caution than he might
otherwise exercise; but if the company’s exhibit is sufficiently
impressive the preferred stock may still be accorded an invest¬
ment rating.

Total-deductions Basis of Calculation Recommended.—In

calculating the earnings coverage for preferred stocks with
bonds preceding, it is absolutely essential that the bond interest
and preferred dividend be taken together . The almost uni¬
versal practice of stating the earnings on the preferred stock
separately (in dollars per share) is exactly similar to, and as
fallacious as, the prior-deductions method of computing the
margin above interest charges on a junior bond. If the preferred
stock issue is much smaller than the funded debt, the earnings
per share will indicate that the preferred dividend is earned
more times than is the bond interest. Such a statement must
either have no meaning at all, or else it will imply that the
preferred dividend is safer than the bond interest of the same
company—an utter absurdity. 2 (See the examples on page 199.)

The West Penn Electric Company Class A stock is in reality a
second preferred issue. In this example the customary statement
makes the preferred dividend appear safer than the bond interest;
and because the Class A issue is small, it makes this second pre¬
ferred issue appear much safer than either the bonds or the first
preferred. The correct statement shows that the Class A

1 Out of the 21 such issues listed on p. 191 eleven were preceded by bonds,
viz.y five public utilities, one railroad, and five (out of 15) industrials.

* See Appendix Note 28, p. 754, for comment upon neglect of this point by
writers of textbooks on investment.

FIXED-VALUE INVESTMENTS

199

Interest and preferred

dividends earned... 2.2 times

Examples of Correct and Incorrect Methods of Calculating
Earnings Coverage for Preferred Stocks

A. Colorado Fuel and Iron Company: 1929 figures

Earned for bond interest . $3,978,000

Interest charges.. 1,628,000

Preferred dividends. 160,000

Balance for common. 2,190,000

Customary but incorrect statement Correct statement

Int. charges earned. 2.4 times Int. charges earned .. 2 4 times

Preferred dividend

earned. 14.7 times

Earned per share of

preferred. $117.50

Note: The preceding statement of
earnings on the preferred stock
alone is either worthless or dan¬
gerously misleading.

B. Warner Bros. Pictures, Inc.: Year ended

Aug. 28, 1937

Earned for interest . $10,760,000

Interest charges. 4,574,000

Preferred dividends. 397,000

Balance for common. 5,789,000

Customary but incorrect statement Correct statement

Int. charges earned. 2 35 times Int. charges earned.. 2.35 times

Preferred dividends

earned . 14.8limc3

Earned per share of

preferred. $56 99

West Penn Electric Company:

Interest and preferred
dividends earned.. 2.1 times

1937 figures

Gross. $40,261,000

Net before charges. 13,604,000

Fixed charges (include preferred dividends of sub¬
sidiaries). 8,113,000

Dividends on 7% and 6% preferred issues. 2,267,000

Dividends on Class A stock (junior to 6 % and 7% Pfd.). 412,000

. 2,812,000

Correct statement
Times earned

Balance for Class B and common
Customary but incorrect statement

Times interest or
dividends earned
Fixed charges... 1.68 times
6% and 7%
preferred

(combined)... 2.42 times
pinna A . 7.43 times

Earned
per share

$16.11

54.79

Fixed charges.. 1.68 times
Charges and
preferred

dividends.... 1.31 times
Fixed charges,
preferred div¬
idends, and
Class A divi¬
dends. 1.26 times

200

SECURITY ANALYSIS

requirements are covered 1.26 times instead of 7.43 times— a
tremendous difference. The erroneous method of stating the
earnings coverage was probably responsible in good part for
the high price at which the Class A shares sold in 1937 (108).
It is interesting to observe that although the Class A shares had
declined to 25 in 1932, they later sold repeatedly at a higher
price than the 7% preferred issue. Evidently some investors
were still misled by the per-share earnings figures, and imagined
the second preferred safer than the first preferred.

An Apparent Contradiction Explained. —Our principles of
preferred-dividend coverage lead to an apparent contradiction,
viz ., that the preferred stockholders of a company must require
a larger minimum coverage than the bondholders of the same
company, yet by the nature of the case the actual coverage is
bound to be smaller. For in any corporation the bond interest
alone is obviously earned with a larger margin than the bond
interest and preferred dividends combined. This fact has
created the impression among investors (and some writers)
that the tests of a sound preferred stock may properly be less
stringent than those of a sound bond. 1 But this is not true at
all. The real point is that where a company has both bonds
and preferred stock the preferred stock can be safe enough only
if the bonds are much safer than necessary. Conversely, if the
bonds are only just safe enough, the preferred stock cannot be
sound. This is illustrated by two examples, as follows:

1 See, for example, the following quotations from R. E. Badger and H. G.
Guthmann, Investment Principles and Pradices } New York, 1941:

‘‘Similarly, it is a general rule that, on the average, the interest on indus¬
trial bonds should be covered at least three times, in order that the bond
should be considered safe” (p. 316).

“From the authors' viewpoint, an industrial preferred stock should be
regarded as speculative unless combined charges and dividend requirements
are earned at least twice over a period of years” (p. 319).

“One is probably safe in stating that, where combined charges are twice
earned, including interest charges on the bonds of the holding company, the
presumption is in favor of the soundness of such holding company issue.
Likewise, where combined prior charges and preferred dividend requirements
are earned 1.5 times, the preferred stock of the holding company will be
favorably regarded” (p. 421).

See also F. F. Burtchett, Investments and Investment Policy , New York,
1938, p. 325, where the author requires larger coverage of fixed charges on
bonds than on preferred stocks of merchandising enterprises.

FIXED-VALUE INVESTMENTS

201

Year

Liggett <fc Myers Tobacco Co.

Commonwealth & Southern Corp.

Number of
times interest
earned

Number of
times int. &nd
pfd. dividend
earned

Number of
times fixed
charges earned

Number of
times fixed
charges and pfd.
dividend earned

7.87

1.84

1.48

■Ell

7.23

1.84

1.55

12.3

6.42

1.71

1.44

1927

11.9

6.20

1 02

1.37

1926

11.2

5.85

1.52

1.31

1925

9.8

5.14

1.42

1.28

The Liggett and Myers preferred-dividend coverage (includ¬
ing, of course, the bond interest as well) is substantially above
our suggested minimum of four times. The bond-interest cover¬
age alone is therefore far in excess of the smaller minimum
required for it, viz., three times. On the other hand, the Com¬
monwealth and Southern fixed-charge coverage in 1930 was just
about at the proposed minimum 1% times. This meant that
while the various bonds might qualify for investment, the 6%
preferred stock could not possibly do so, and the purchase
of that issue at a price above par in 1930 was an obvious mistake.

“Dollars-per-share” Formula Misleading .—When a preferred
stock has no bonds ahead of it, the earnings may be presented
either as so many dollars per share or as so many times dividend
requirements. The second form is distinctly preferable, for
two reasons. The more important one is that the use of the
“dollars per share” formula in cases where there are no bonds
is likely to encourage its use in cases where there are bonds.
Security analysts and intelligent investors should make special
efforts to avoid and decry this misleading method of stating
preferred-dividend coverage, and this may best be accomplished
by dropping the dollars-per-share form of calculation entirely.
As a second point, it should be noted that the significance of
the dollars earned per share is dependent upon the market price
of the preferred stock. Earnings of $20 per share would be
much more favorable for a preferred issue selling at 80 than for
a preferred selling at 125. In the one case the earnings are 25%,
and in the other only 16 %, on the market price. The dollars-per-

SECURITY ANALYSIS

202

share figure loses all comparative value when the par value is
less than $100, or when there is no-par stock with a low dividend
rate per share. Earnings of $18.60 per share in 1931 on S. H.
Kress and Company 6% Preferred (par $10) are of course far
more favorable than earnings of $20 per share on some 7% pre¬
ferred stock, par $100.

Calculation of the Stock-value Ratio.—The technique of
applying this test to preferred stocks is in all respects similar
to that of the earnings-coverage test. The bonds, if any, and
the preferred stock must be taken together and the total com¬
pared with the market price of the common stock only. When
calculating the protection behind a bond, the preferred issue is
part of the stock equity; but when calculating the protection
behind the preferred shares, the common stock is now, of course,
the only junior security. In cases where there are both a first
and second preferred issue, the second preferred is added to the
common stock in calculating the equity behind the first preferred.

Example of Calculation of Stock-value Ratios for Preferred Stocks
Procter and Gamble Company

Capitalization

Face amount

Low

price

1932

Value at low
price in 1932

Bonds.

$10,500,000

2,250,000

17,156,000

6,140,000*

$ 3,150,000
13,900,000
128,200,000

8% pfd. (1st pfd.).

5% pfd. (2d pfd.).

Common.

* N umber of shares.

A . Stock-value ratio
for bonds

B . Stock-value ratio
for 1st pfd.

C. Stock-value ratio
for 2d pfd.

3,150,000 -f- 13,900,000 + 128,200,000
10,500,000

13,900,000 4- 128,200,000
10,500,000 + 3,150,000

128,200,000

10,500,000 + 3,150,000 + 13,900,000

Should the market value of the common stock be compared
with the par value or the market value of the preferred? In the
majority of cases it will not make any vital difference which
figure is used. There are, however, an increasing number of
no-par-value preferreds (and also a number like Island Creek Coal
Company Preferred and Remington Rand, Inc., Second Preferred

FIXED-VALUE INVESTMENTS

203

in which the real par is entirely different from the stated par). 1
In these cases an equivalent would have to be constructed from
the dividend rate. Because of such instances and also those
where the market price tends to differ materially from the par
value ( e.g ., Norfolk and Western Railway Company 4% Pre¬
ferred in 1932 or Eastman Kodak 6% Preferred in 1939), it
would seem the better rule to use the market price of preferred
stocks regularly in computing stock-value ratios. On the other
hand the regular use of the face value of bond issues, rather than
the market price, is recommended, because it is much more
convenient and does not involve the objections just discussed in
relation to preferred shares.

Noncumulative Issues.—The theoretical disadvantage of a
noncumulative preferred stock as compared with a cumulative
issue is very similar to the inferiority of preferred stocks in
general as compared with bonds. The drawback of not being
able to compel the payment of dividends on preferred stocks
generally is almost matched by the handicap in the case of
noncumulative issues of not being able to receive in the future the
dividends withheld in the past. This latter arrangement is so
patently inequitable that new security buyers (who will stand
for almost anything) object to noncumulative issues, and for
many years new offerings of straight preferred stocks have almost
invariably had the cumulative feature. 2 Noncumulative issues
have generally come into existence as the result of reorganization
plans in which old security holders have been virtually forced to
accept whatever type of security was offered them. But in
recent years the preferred issues created through reorganization
have been preponderantly cumulative, though in some cases this
provision becomes operative only after a certain interval.

1 Island Creek Coal Preferred has a stated par of $1 and Remington Rand,
Inc., Second Preferred has a stated par of $25, but both issues carry a $6
dividend and they are entitled to $120 per share and $100 per share respec¬
tively in the event of liquidation. Their true par is evidently $100. The
same is true of American Zinc Lead and Smelting First $5 Prior Preferred
and $6 (Second) Preferred; par of each is $25.

1 The only important “straight,” noncumulative preferred stock sold to
stockholders or the public since the war was St. Louis-San Francisco Railway
Company Preferred. In the case of Illinois Central Railroad Company
Noncumulative Preferred, the conversion privilege was the overshadowing
inducement at the time of issue.

204

SECURITY ANALYSIS

Austin Nichols and Company $5 Preferred, for example, was
issued under a Readjustment Plan in 1930 and became cumula¬
tive in 1934. National Department Stores Preferred, created in
1935, became fully cumulative in 1938.

Chief Objection to Noncumulative Provision .—One of the chief
objections to the noncumulative provision is that it permits the
directors to withhold dividends even in good years, when they
are amply earned, the money thus saved inuring to the benefit
of the common stockholders. Experience shows that non¬
cumulative dividends are seldom paid unless they are necessitated
by the desire to declare dividends on the common; and if the
common dividend is later discontinued, the preferred dividend is
almost invariably suspended soon afterwards. 1

Example: St. Louis-San Francisco Railway Company affords a
typical example. No dividends were paid on the (old) preferred
issue between 1916 and 1924, although the dividend was fully
earned in most of these years. Payments were not commenced
until immediately before dividends were initiated on the common;
and they were continued (on the new preferred) less than a year
after the common dividend was suspended in 1931.

The manifest injustice of such an arrangement led the New
Jersey courts (in the United States Cast Iron Pipe case) 2 to
decide that if dividends are earned on a noncumulative preferred
stock but not paid, then the holder is entitled to receive such
amounts later before anything can be paid on the common. This
meant that in New Jersey a noncumulative preferred stock was
given a cumulative claim on dividends to the extent that they
were earned. The United States Supreme Court however,
handed down a contrary decision (in the Wabash Railway case) 3

1 Kansas City Southern Railway Company 4 % Noncumulative Preferred,
which paid dividends between 1907 and 1929 while the common received
nothing, is an outstanding exception to this statement. St. Louis South¬
western Railway Company 5% Noncumulative Preferred received full
dividends during 1923-1929 while no payments were made on the common;
but for a still longer period preferred dividends, although earned, were
wholly or partially withheld (and thus irrevocably lost).

a Day v. United States Cast Iron Pipe and Foundry Company , 94 N.J. Eq.
389, 124 Atl. 546 (1924), ajftt 96 N.J. Eq. 738, 126 Atl. 302 (1925); Moran v .
United States Cast Iron Pipe and Foundry Company , 95 N.J. Eq. 389, 123
Atl. 546 (1924), affd, 96 N.J. Eq. 698, 126 Atl. 329 (1925).

* Wabash Railway Company et al. v. Barclay et al. t 280 U.S. 197 (1930),
reversing Barclay v. Wabash Railway , 30 Fed. (2d) 260 (1929). See dia-

FIXED-VALUE INVESTMENTS

205

holding that while the noncumulative provision may work a great
hardship on the holder, he has nevertheless agreed thereto when
he accepted the issue. This is undoubtedly sound law, but the
inherent objections to the noncumulative provision are so
great (chiefly because of the opportunity it affords for unfair
policies by the directors) that it would seem to be advisable
for the legislatures of the several states to put the New Jersey
decision into statutory effect by prohibiting the creation of
completely noncumulative preferred stocks, requiring them to
be made cumulative at least to the extent that the dividend is
earned. This result has been attained in a number of individual
instances through insertion of appropriate charter provisions. 1

Features of the List of 21 Preferred Issues of Investment
Grade. —Out of some 440 preferred stocks listed on the New York
Stock Exchange in 1932, only 40, or 9%, were noncumulative.
Of these, 29 were railroad or street-railway issues and only 11
were industrial issues. The reader will be surprised to note,
however, that out of only 21 preferred stocks selling continu¬
ously on an investment basis in 1932, no less than four were lion-
cumulative. Other peculiarities are to be found in this favored
list, and they may be summarized as follows (see page 191):

1. Both the number of noncumulative issues and the number of preferred
stocks preceded by bonds are proportionately higher among the 21
“good” companies than in the Stock Exchange list as a whole.

2. The industry best represented is the snuff business, with three companies.

3. Miscellaneous peculiarities:

a. Only one issue has a sinking fund provision.

b. One issue is a second preferred (Procter and Gamble).

c. One issue has a par value of only SI (Island Creek Coal).

d . One issue was callable at close to the lowest market price of 1932-
1933 (General Electric).

cussion in A. A. Bcrle, Jr., and G. C. Means, The Modern Corporation and
Private Property, pp. 190-192.

1 See, for example, the provisions of George A. Fuller Company $3 Con¬
vertible Stock; Aeolian Company 6% Class A Preferred; United States
Lines Company Convertible Second Preferred. A trend in the direction
of preferred stocks with this type of provision is observable in numerous
recent reorganization plans of railroads. See various plans presented in
1936-1938 for Chicago and Eastern Illinois Railroad, Missouri Pacific
Railroad, Eric Railroad, St. Louis-San Francisco Railroad. An early
example of this type of preferred is that of Pittsburgh, Youngstown and
Ashtabula Railway. But here the dividend becomes cumulative only if the
full $7 rate is earned and less has been paid.

206

SECURITY ANALYSIS

Matters of Form , Title, or Legal Right Relatively Immaterial —
We trust that no overzealous exponent of the inductive method
will conclude from these figures either: (1) that noncumulative
preferreds are superior to cumulative issues; or (2) that preferreds
preceded by bonds are superior to those without bonds; or (3)
that the snuff business presents the safest opportunity for
investment. The real significance of these unexpected results
is rather the striking confirmation they offer to our basic thesis
that matters of form, title, or legal right are relatively immaterial,
and that the showing made by the individual issue is of para¬
mount importance. If a preferred stock could always be
expected to pay its dividend without question, then whether
it is cumulative or noncumulative would become an academic
question solely, in the same way that the inferior contractual
rights of a preferred stock as compared with a bond would cease
to have practical significance. Since the dividend on United
States Tobacco Company Preferred was earned more than six¬
teen times in the depression year 1931—and since, moreover, the
company had been willing to buy in a large part of the preferred
issue at prices ranging up to $125 per share—the lack of a
cumulative provision caused the holders no concern at all. This
example must of course, be considered as exceptional; and as a
point of practical investment policy we should suggest that no
matter how impressive may be the exhibit of a noncumulative
preferred stock, it would be better to select a cumulative issue for
purchase in order to enjoy better protection in the event of
unexpected reverses. 1

1 See, for example, the record of American Car and Foundry Company
7% Noncumulative Preferred. For many years prior to 1928 this issue sold
higher than United States Tobacco Company 7 % Noncumulative Preferred.
By 1929 it had completed 30 years of uninterrupted dividend payments,
during the last 20 of which its market price had never fallen below 100.
Yet in 1932 the dividend was passed and the quotation declined to 16.
Similarly, Atchison, Topeka and Santa Fe Railway Company Preferred,
a 5% noncumulative issue, paid full dividends between 1901 and 1932 and
was long regarded as a gilt-edged investment. As late as 1931 the price
reached 108 within a half-point of the highest level in its history , and a
yield of only 4.6%. The very next year the price fell to 35, and in the
following year the dividend was reduced to a $3 basis. It was later restored
to 5 %, but in 1938 the dividend was omitted entirely. This history might
be pondered by investors willing to pay 112 for Norfolk and Western 4%
Noncumulative Preferred in 1939,

FIXED-VALUE INVESTMENTS

207

Amount Rather Than Mere Presence of Senior Obligations
Important. —The relatively large number of companies in our list
having bonds outstanding is also of interest, as demonstrating
that it is not the mere presence of bonds, but rather the amount
of the prior debt which is of serious moment. In three cases
the bonds were outstanding in merely a nominal sum, as the
result of the fact that nearly all of these companies had a long
history, so that some of them carried small residues of old bond
financing. 1

By a coincidence all three of the noncumulative industrial
preferred stocks in our list belong to companies in the snuff
business. This fact is interesting, not because it proves the
investment primacy of snuff, but because of the strong reminder
it offers that the investor cannot safely judge the merits or
demerits of a security by his personal reaction to the kind of
business in which it is engaged. An outstanding record for a long
period in the past, plus strong evidence of inherent stability,
plus the absence of any concrete reason to expect a substantial
change for the worse in the future, afford probably the only sound
basis available for the selection of a fixed-value investment.
The miscellaneous peculiarities in our list (mentioned under
3, above) are also useful indications that matters of form or
minor drawbacks have no essential bearing on the quality of an
investment.

1 These companies wore General Electric, American Tobacco, and Com
Products Refining. The University cf Michigan study by Dr. Rodkcy
recognizes this point in part by ignoring certain bond issues amounting to
less than 10 % of capital and surplus.

CHAPTER XVI

INCOME BONDS AND GUARANTEED SECURITIES

I. INCOME BONDS

The contractual position of an income bond (sometimes
called an adjustment bond) stands midway between that of a
straight bond and a preferred stock. Practically all income
obligations have a definite maturity, so that the holder has an
unqualified right to repayment of his principal on a fixed date.
In this respect his position is entirely that of the ordinary
bondholder. However, it should be pointed out that income
bonds are almost always given a long maturity date, so that the
right of repayment is not likely to be of practical importance in
the typical case studied. In fact we have discovered only one
instance of income bondholders actually having received repay¬
ment of their principal in full by reason of maturity. 1

Interest Payment Sometimes Wholly Discretionary.—In the
matter of interest payments some income bonds are almost
precisely in the position of a preferred stock, because the directors
are given practically complete discretion over the amounts to
be paid to the bondholders. The customary provisions require
that interest be paid to the extent that income is available, but
many indentures permit the directors to set aside whatever
portion of the income they please for capital expenditures or
other purposes, before arriving at the 11 available” balance. In

1 This was a $500,000 issue of Milwaukee Lake Shore and Western Income
6s, issued in 1881, assumed by the Chicago and Northwestern in 1891, and
paid off at maturity in 1911. St. Louis-San Francisco Railway Company
Income 6s and Adjustment 6s were both called for repayment at par in 1928,
which was 32 and 27 years, respectively, prior to their maturity. This
proved fortunate for the bondholders since the road went into receivership
in 1932. The history of the ’Frisco between its emergence from receivership
in 1916 and its subsequent relapse into receivership in 1932 is an extraordi¬
nary example of the heedlessness of both investors and speculators, who were
induced by a moderate improvement, shown in a few years of general
prosperity, to place a high rating on the securities of a railroad with a poor
previous record and a topheavy capital structure,

208

FIXED-VALUE INVESTMENTS

209

the case of the Green Bay and Western Railroad Company
Income Debentures “ Series B,” the amounts paid out between
1922 and 1931, inclusive, aggregated only 6% although the earn¬
ings were equal to only slightly less than 22%. The more recent
indentures ( e.g ., Colorado Fuel and Iron Company Income 5s,
due 1970) tend to place definite limits on the percentage of
earnings which may be withheld in this manner from the income
bondholders; but a considerable degree of latitude is usually
reserved to the directors. It may be said that individual
income-bond issues may be found illustrating almost every step
in the range of variation between straight preferred stocks and
ordinary bonds.

Low Investment Rating of Income Bonds as a Class.—Since
the contractual rights of income bonds are always more or less
superior to those of preferred stocks, it might be thought that
a greater proportion of income bonds than of preferred stocks
would deserve an investment rating. Such is not the case,
however. In fact we know of only one income obligation which
has maintained an investment standing continuously over any
length of time, viz., Atchison Topeka and Santa Fe Railway
Company Adjustment 4s, due 1995. 1 We have here a contrast
between theory and actuality, the reason being, of course, that
income bonds have been issued almost exclusively in connection
with corporate reorganizations and have therefore been associated
with companies of secondary credit standing. The very fact that

1 After more than forty years of uninterrupted interest payments, this
issue lapsed temporarily from grace in 1938. May 1 interest (on bonds
entitled to semiannual interest) was deferred but paid six months later.
The price dropped from 103 to 75 but recovered to 96 —all in the year
1938. This recovery is a striking commentary on the eagerness of investors
for so-called “prime bonds.”

Some guaranteed income bonds of leased railroads have maintained a
high investment standing, similar to that of guaranteed railroad stocks.
Example: Elmira and Williamsport Railroad Income 5s, due 2862, guaran¬
teed by Pennsylvania Railroad and by an important subsidiary. (Note
the 1,000-year maturity.) Also observe the superior position of Chicago
Terre Haute and South Eastern Income 5s, guaranteed by the Chicago,
Milwaukee, St. Paul and Pacific Railroad, in the reorganization of that
system (infra p. 215).

Among the newer crop of income bonds, one has qualified as an invest¬
ment issue almost from the start: Allied Owners Corporation 4s-5s, virtually
guaranteed by Loews, Inc. In the authors* view, there was no excuse for
making this an income bond in the reorganization of 1936.

210

SECURITY ANALYSIS

the interewst payments are dependent on earnings implies Un¬
likelihood that the earnings may be insufficient. Preferred-stock
dividends are equally dependent upon earnings, but the same
implication is not associated with them. Hence the general
investment status of income bonds as a class is seen to have been
governed by the circumstances under which they are created
rather than by the legal rights which attach to them. To use an
analogy: If it had been the general practice here, as in England,
to avoid mortgage-bond issues wherever possible, using them
only where doubtful credit made this protection necessary, then
we might find that mortgage bonds in general would occupy an
investment position distinctly inferior to that of debenture bonds. 1

Increased Volume of Income Bonds Probable. —Looking for¬
ward, it may be true that in the future income obligations will
show a larger proportion of investment issues than will be found
among preferred stocks. The numerous reorganizations growing
out of the 1930-1933 depression and the continued weakness of
railway earnings have created a large new crop of income bonds,
and some of these companies may later so improve their position
as to place their income obligations in the investment class, as
happened to the Atchison, Topeka and Santa Fe after its reor¬
ganization in 1895. There is also the point, so far almost
overlooked, that income bonds effect a substantial saving in
corporation taxes as compared with preferred stocks, without
important offsetting disadvantages. Some strong companies
may some day be led to replace their present preferred stocks—or
to do their new financing—by income obligations, for the sake of
this tax saving, in the same way as they are now creating artifi¬
cially low par values for their shares to reduce the transfer taxes
thereon. A development of this kind in the future might result
in a respectable number of income-bond issues deserving to
rank as fixed-value investments. 2

Calculations of Margins of Safety for Income Bonds. —The
technique of analyzing an income-bond exhibit is identical with

1 This actually proved to be the case in the industrial financing of 1937-
1939. Practically all the bond issues were debentures and were sold at
unusually low interest rates. It may be said, we believe, that industrial
debentures now connote a higher type of security than industrial mortgage
bonds.

a The Associated Gas and Electric Company used the device of “bonds”
convertible into preferred stock at the option of the company , and obtained
this tax saving without the burden of a fixed bond obligation. The income-

FIXED-VALUE INVESTMENTS

211

that for a preferred stock. Computations of earnings on the
issue taken separately must, of course, be rigorously avoided,
although such calculations are given by the statistical agencies.

We suggest that the minimum-earnings coverage recommended
in the preceding chapter for preferred stocks be required also for
income bonds when selected as fixed-value investments.

Example: The following analysis of the Missouri-Kansas-Texas
Railroad Company income account for 1930 will illustrate the
proper method of dealing with all the senior securities of a com¬
pany having adjustment bonds. It also shows how the two
methods of figuring the fixed charges of a railroad system (dis¬
cussed in Chap. XII) are to be applied to the analysis of income
bonds and preferred stock.

Missouri-Kansas-Texas Railroad Company, Calendar Year 1930

(All dollar figures in thousands)

Gross revenue. $45,949

Railway operating income (net after taxes) . 13,353

Gross income (net after rents, plus other income) 12,009
Fixed charges (fixed interest and other deductions). . 4,230

Balance for adjustment interest. . 7,779

Adjustment interest. 096

Balance for dividends (net income). . 7,083

Preferred dividends. 4,645

Balance for common. . 2,438

Net after taxes exceeds gross income. lienee use net-deductions test.

Net deductions = difference between net after taxes and balance for adjust¬
ment interest

= $13,353 - $7,779.

Net deductions = $ 5,574

Net deductions and adjustment interest = 6,270

Net deductions, adjustment interest and pro- = $10,915
ferred dividends

Times earned
$13,353

$ 5,574
$13,353
$ 6,270
$13,353
$10,915

= 2.40

= 2.14

—- = 1 oo

bond form would have been far less misleading to the ordinary investor than
this extraordinary invention.

Income bonds have been favored over preferred stocks in railroad
reorganizations because of legal restrictions on insurance companies which
would prohibit them from holding preferred shares in place of their old
bonds. Conceivably this consideration, as well as the tax saving, could
induce corporations to do new financing through income bonds in lieu of
preferred stocks.

212

SECURITY ANALYSIS

Note that interest on income or adjustment bonds is not
part of the total interest charges when calculating the coverage
for the fixed-interest bonds. In this respect the position of
an income bond is exactly that of a preferred stock. Note also
that the statement made by the statistical services that 57.29%
was earned on the M-K-T Adjustment 5s. (t.c., that the “interest
was covered” more than eleven times) is valueless or misleading.

Significance of These Figures for the Investor in Early 1931.—
The 1930 earnings were somewhat lower than the ten-year
average and could then apparently be viewed as a fair indication
of the normal earning power of M-K-T. The coverage for
the preferred stock was clearly inadequate from any investment
standpoint. The coverage for the adjustment-bond interest on
the more conservative basis (the net-deductions method) was
below our minimum requirement of 2 % times, so that this issue
would not have qualified for investment. The coverage for the
fixed-bond interest was substantially above our minimum and
indicated a satisfactory degree of protection.

Naturally the disastrous decline of earnings in 1931-1933 could
not have been foreseen or fully guarded against. The market
price of M-K-T fixed obligations suffered severely in 1932; but
since the company’s debt structure was relatively conservative,
it did not come so close to insolvency as the majority of other
carriers. In fact, the 1932-1934 interest was paid on the
adjustment bonds, although such payment was not obligatory.

Subsequent developments are worth describing because of their
practical bearing on bond investment. The following table
should prove instructive:

Year

Balance for
interest

Net deductions
earned, times

Range for year

4%s, 1978

Adj. 5s

1930

11,999,000

2.40

92%-101

86 -108M

5,579,000

1.22

43%- 98

34 - 95

4,268,000

1.01

36 - 70K

13 - 60

3,378,000

0.86

55 - 77H

32 %- 65

2,093,000

0.65

29 - 62M

2,457,000

0.71

28%- 64

UK- 36 K

4,773,000

1.09

52H- 83

30 K- 74 %

3,274,000

0.86

38 - 79 H

18 K- 80

1,120,000

0.49

26 - 46%

10-24

FIXED-VALUE INVESTMENTS

213

It will be seen that the 1930 earnings did not in fact prove a
guide to the future normal earning power of M-K-T. Yet this
mistake need not have proved very costly to an individual inves¬
tor who bought the fixed-interest bonds in 1931. Despite the
decline in earnings and investment quality, he had several oppor¬
tunities to sell out advantageously during the next six years.
As we point out later (Chap. XXI), proper investment technique
would have compelled such a sale, in view of the changed exhibit.

After 1934, interest on the adjustment bonds was paid only in
1937. The price range of that issue is interesting chiefly as a
reflection of the heedlessness of bond buyers. Note that at the
1937 highs they paid the same price for the adjustment 5s as
for the 4J£s, despite the totally inadequate earnings coverage,
and despite the fact that in 1932, 1934 and 1935 the senior
issue had sold more than twice as high as the adjustments.

Senior Income Bonds.—There are a few instances of income
bonds which are senior in their lien to other bonds bearing fixed
interest. The Atchison Adjustment 4s are the best known
example, being followed by 4% fixed-interest debenture issues
which have regularly sold at a lower price except briefly in 1938.
The situation holds true also with respect to St. Louis South¬
western Railway Company Second Income 4s. 1 While the
theoretical status of such bonds is rather confusing, the prac¬
tical procedure called for is, obviously, to treat the interest
thereon as part of the company 1 *s fixed charges , when dealing with
the system as a whole.

H. GUARANTEED ISSUES

No special investment quality attaches to guaranteed issues
as such. Inexperienced investors may imagine that the word

1 The various reorganization plans for this road (1936-1939) all give the
Second Income 4s much better treatment than is offered the junior fixed-
interest issues. An unusual case is afforded by Wabash Railway Non-
cumulative Income Debenture 6s, due 1939, interest on which was payable
“from net income.” Although called debentures, they are secured by a
direct lien and have priority over the Wabash Railroad Refunding and
General Mortgage. Although entitled by their terms only to noncumu-
lative interest dependent on earnings, this interest was paid regularly from
1916 through 1938, despite the fact that the company entered receivership in
1931 and defaulted upon the junior-mortgage (fixed) interest in 1932.
This issue was also given superior treatment in the various reorganization
plans for the Wabash filed to the end of 1939.

214

SECURITY ANALYSIS

“guaranteed” carries a positive assurance of safety; but, needless
to say, the value of any guaranty depends strictly upon the
financial condition of the guarantor. If the guarantor has
nothing, the guaranty is worthless. In contrast with the
attitude of the financial novice, Wall Street displays a tendency
to underestimate the value of a guaranty, as shown by the lower
prices often current for guaranteed issues in comparison with the
debentures or even the preferred stock of the guarantor. This
sophisticated distrust of guarantees dates back to the Kanawha
and Hocking Coal and Coke Company case in 1915, when the
guarantor railroad endeavored to escape its liability by claiming
that the guaranty, made in 1901, was beyond its corporate powers
and hence void. This attempt at evasion, encouraged by the
outcome of antitrust suits in the Ohio and federal courts, in the
end proved completely unsuccessful; but it cast a shadow over
the value of all guarantees, from which they have not completely
emerged even after 25 years. 1 We know of no important case
in which a solvent company has escaped the consequences of its
guaranty through legal technicalities. 2

Status of Guaranteed Issues. —If a company guarantees
interest, dividend, or principal payments, its failure to meet
this obligation will expose it to insolvency. The claim against
the guarantor ranks equally with an unsecured debt of the
company, so that guaranteed issues deserve the same rating
as a debenture bond of the guarantor and a better rating than
its preferred stock. A guaranteed issue may also be entitled

1 A condensed history of this famous case is given on pp. God G57 of the
1934 edition of this book.

2 However, the shadowy form of ‘‘insolvency ” provided for in Chap. XI
of the Chandler (Federal Bankruptcy) Act has been availed of to induce
holders of guaranteed issues to modify their contract without sacrifice by
the guarantor company and to force acceptance of the modified terms by
minority holders. Example: Modification of guaranty of Trinity Building
5J£s by United States Realty and Improvement proposed in March 1939.

Contrast this with the full payment in October 1932 of the unpurchascd
portion of Savoy Plaza Corporation Debenture 5%s f which had also been
guaranteed by United States Realty and Improvement. At that time
unguaranteed First Mortgage bonds of Savoy Plaza had been selling as low
as 5. Note also the full payment in 1939 of Utica Clinton and Binghamton
Railroad First 5s through funds supplied by Delaware and Hudson Railroad,
the guarantor, although Delaware and Hudson had not been operating the
line for a great many years.

FIXED-VALUE INVESTMENTS

215

to an investment rating because of its own position and earning
power independent of the guaranty. In such cases the guaranty
may add to its security, but it cannot detract therefrom even if
the guarantor company itself is in bad straits.

Examples: The Brooklyn Union Elevated Railroad 5s (see
page 35) were guaranteed by the Brooklyn Heights Railroad
Company, which went into receivership in 1919; but the bond
came through the reorganization unscathed because of its own
preferred position in the Brooklyn Rapid Transit System.
Similarly U. S. Industrial Alcohol Company Preferred dividends
were guaranteed by Distilling Company of America; the latter
enterprise became bankrupt, but the Alcohol Company was
easily able to continue the dividend out of its own earnings and
later to retire the preferred issue at 125.

A common or preferred stock fully guaranteed by another
company has the status of a bond issue as far as the guarantor
is concerned. If the guaranty proves worthless, it would natu¬
rally return to the position of a stock—usually a weak issue,
but possibly a strong one, as in the case of U. S. Industrial Alcohol
Company Preferred just mentioned. A similar situation obtains
with respect to income bonds of one company guaranteed by
another ( e.g., Chicago, Terre Haute, and Southeastern Railway
Company Income 5s, 1 guaranteed by the Chicago, Milwaukee,
St. Paul and Pacific Railroad Company).

The value of a guarantee is sometimes very evident when part
of an issue is guaranteed and part is not.

Example:

Anacostia and Potomac River Railroad First 5s, Due 1949
$500,000 guaranteed by Washington Ry. &

Elec. Co. price 110 in 1939

$2,100,000 unguaranteed. price 80 in 1939

In this case the Anacostia company's earnings coverage was
inadequate (1.36 times in 1938), but that of the guarantor com-

1 Interest was continued on these incon^ bonds (through 1939) despite
receivership of the guarantor company in 1935 and default on all its own
obligations. This was due not to the guarantee but to the strategic impor¬
tance and substantial earnings of the Terre Haute division. Note that in
this case a divisional second-mortgage income bond fared substantially better
than the first mortgage on the main line of the system. Not the terms but the
facts determine investment performance.

216

SECURITY ANALYSIS

pany was high (over 4 times in 1938 on a consolidated basis’
and over 11 times in that year on a parent-only basis inclusive of
interest for which it was contingently liable).

Exact Terms of Guaranty Are Important. —The exact terms
of a guaranty have obviously a vital influence upon its value.
A guaranty of interest only is likely to be much less significant
than a guaranty of principal as well.

Examples: Philippine Railway Company First 4s, due 1937,
were guaranteed as to interest only by the Philippine govern¬
ment. The earnings of the road itself were poor. Interest was
paid promptly up to maturity, but principal was defaulted. The
price of the bond reflected this situation, having sold no higher
than 39 since 1929. 1

Minneapolis, St. Paul and Saulte Saint Marie Railroad First
Consolidated 4s and 5s due 1938: All the 4% bonds and about
half the 5% bonds were guaranteed as to interest only by
Canadian Pacific Railway. Principal was defaulted on maturity,
and the Canadian Pacific ceased to pay interest, the price of the
bonds declining to 6. 2

On the other hand, this company's First and Refunding 5%s,
Series B , due 1978,—a junior lien—are also guaranteed as to
interest by Canadian Pacific and in accordance with the guaranty
continued to receive interest after the senior lien was in default.
These bonds sold at 64 in 1939, whereas the senior issues sold at
6. Note that in 1931 they sold as low as 35, whereas the 1st
Consolidated Guaranteed 5s, due 1938, sold at 45 and the Cana¬
dian Pacific (unsecured) Debenture stock sold at 56%. It is
clear that the value of the long-term Canadian Pacific guaranty
was not fully appreciated in 1931.

A similar disadvantage attaches to a guaranty of dividends
running for a limited period.

Examples: The actual working out of such a situation was
shown in the case of American Telegraph and Cable Company
common stock, which was guaranteed as to 5% dividends (only)
for 50 years from 1882 by the Western Union Telegraph Company

1 Efforts made by a protective committee to induce the Philippine
government to buy the bonds or assume liability for the principal resulted
only in a scandal and a jail sentence for the chairman of the committee in
1939. The bonds sold at 7 in 1939.

* Bondholders brought legal action in 1939 to compel Canadian Pacific
to continue to pay interest until the principal was discharged.

FIXED-VALVE INVESTMENTS

217

under a lease terminating in 1932. Because of the long record
of dividend payments, investors came finally to consider the
dividend as a fixture, and as late as 1922 the stock sold at 70.
But in the meantime the strategic or trade value of the leased
cable properties was rapidly diminishing, so that the value of the
stock at the expiration of the lease was likely to be very small. A
settlement was made in 1930 with Western Union under which
the American Telegraph and Cable stockholders received the
equivalent of about $20 for the principal of their stock. 1

A rather unusual example of the importance of the exact
terms of a guaranty was supplied by Pratt and Whitney Pre¬
ferred (retired in 1928). According to the security manuals,
the dividend on this issue was “guaranteed” by its parent
company, Niles-Bement-Pond. But in fact the Niles company
agreed to make up unpaid dividends on Pratt and Whitney
Preferred only to the extent that Niles had earnings available
therefor after payment of its own preferred dividends. Hence
no dividends were received by Pratt and Whitney Preferred
stockholders from November 1924 to June 1926 without any
claim being enforceable against Niles-Bement-Pond. In view of
the possibility of such special provisions, particular care must be
exercised to obtain complete information regarding the terms of a
guaranty before purchasing any security on the strength thereof.

Joint and Several Guarantees. —Such guarantees are given by
more than one company to cover the same issue, and each com¬
pany accepts responsibility not only for its pro rata share but
also for the share of any other guarantor who may default. In
other words, each guarantor concern is potentially liable for the
entire amount of the issue. Since two or more sponsors are
better than one, bonds bearing a joint and several guarantee
are likely to have special advantages.

Example: The most familiar class of issues backed by such a
guaranty are the bonds of union railroad stations. An outstand¬
ing example is supplied by Kansas City Terminal Railway
Company First 4s, due 1960, which are guaranteed jointly and

1 An alert investor might have taken warning of this possibility from
statements contained in the annual reports of Western Union, starting with
1913, wherein this company’s own holdings of American Telegraph and
Cable Btock were written down annually towards an estimated value of $10
per share in 1932.

218

SECURITY ANALYSIS

severally by no less than 12 railroads, all of which use the com¬
pany’s facilities. The 12 guarantors are as follows: Atchison,
Alton, Burlington, St. Paul, Great Western, Rock Island, Kansas
City Southern, M-K-T, Missouri Pacific, ’Frisco, Union Pacific
and Wabash.

The value of each of these individual guarantees has varied
greatly from road to road and from time to time, but at least
three of the companies have consistently maintained sufficient
financial strength to assure a Terminal bondholder that his
obligation would be met without difficulty. Investors have not
fully appreciated the superior protection accorded by the com¬
bined responsibility of the 12 carriers as compared with the
liability of any one of them singly. The price record shows
that the Kansas City Terminal Railway Company 4s frequently
sold at no higher prices than representative issues of individual
guarantor companies which later turned out to be of question¬
able soundness, whereas at no time was the safety of the Terminal
bond ever a matter of doubt. 1

It would seem good policy for investors, therefore, to favor
bonds of this type, which carry the guaranty of a number of
substantial enterprises, in preference to the obligations of a
single company.

Federal Land Bank Bonds. —A somewhat different aspect of
the joint and several guarantee appears in the important case
of the Federal Land Bank bonds, which are secured by deposit of
farm mortgages. The obligations of each of the 12 separate
banks are guaranteed by the 11 others, so that each Federal Land
Bank bond is in reality a liability of the entire system. When
these banks were organized, there was created concurrently a
group of Joint Stock Land Banks which also issued bonds, but
the obligations of one Joint Stock Bank were not guaranteed
by the others. 2 Both sets of land banks were under United
States government supervision and the bonds of both were made
exempt from federal taxation. Practically all of the stock of

1 See Appendix Note 30, p. 755, for supporting data.

2 The word *' 1 Joint” in the title referred to the ownership of the stock by
various interests, but it may have created an unfortunate impression among
investors that there was a joint responsibility by the group of banks for the
liabilities of each. For a comprehensive account and criticism of these
banks, see Carl H. Schwartz, “Financial Study of the Joint Stock Land
Banks,” Washington, D. C.,1938.

FIXED-VALUE INVESTMENTS

219

the Federal Land Banks was subscribed for originally by the
United States government (which, however, did not assume
liability for their bonds); the Joint Stock Land Bank shares were
privately owned.

At the inception of this dual system, investors were disposed
to consider the federal supervision mid tax exemption as a
virtual guarantee of the safety of the Joint Stock Land Bank
bonds, and they were therefore willing to buy them at a yield
only 3^2% higher than that returned by the Federal Land Bank
bonds. In comparing the nonguaranteed Joint Stock bonds with
the mutually guaranteed federal bonds, the following observa¬
tions might well have been made:

1. Assuming the complete success of the farm-loan system, the guarantee
would be superfluous, since each bond issue separately would have enjoyed
ample protection.

2. Assuming complete failure of the system, the guarantee would prove
worthless, since all the banks would be equally insolvent.

3. For any intermediate stage between these two extremes, the joint and
several guarantee might prove extremely valuable. This vould be particu¬
larly true as to bonds of a farm-loan district subjected to extremely adverse
conditions of a local character.

In view of the fact that the farm-loan system tvas a new and
untried undertaking, investors therein should have assured
themselves of the largest possible measure of protection. Those
who in their eagerness for the extra 1 2 % of income return dis¬
pensed with the joint guarantee committed a patent mistake of
judgment. 1

1 A number of the Joint Stock bond issues defaulted during 1930-1932,
a large proportion sold at receivership prices, and all of them declined to a
speculative price level. On the other hand, not only were there no defaults
among the Federal Land Bank bonds, but their prices suffered a relatively
moderate shrinkage, remaining consistently on an investment level. This
much more satisfactory experience of the investor in the Federal Land Bank
bonds was due in good part to the additional capital subscribed by the
United States government to these Banks, and to the closer supervision to
which they were subjected, but the joint and several guarantee undoubtedly
proved of considerable benefit.

Note also that Joint Stock Land Bank bonds were made legal invest¬
ments for trust funds in many states, and remained so after 1932 despite
their undoubtedly inadequate security. Since May 1933 the Joint Stock
Land Banks have been prohibited from taking on new business, and orderly
liquidation has been in process.

CHAPTER XVII

GUARANTEED SECURITIES (< Continued)

GUARANTEED REAL ESTATE MORTGAGES AND MORTGAGE

BONDS

The practice of guaranteeing securities reached its widest
development in the field of real estate mortgages. These
guarantees are of two different types: the first being given by
the corporation engaged in the sale of the mortgages or mortgage
participations (or by an affiliate); the second and more recent
form being the guaranty given by an independent surety com¬
pany, which assumes the contingent liability in return for a fee.

The idea underlying real estate mortgage guarantees is evi¬
dently that of insurance. It is to the mortgage holder's advan¬
tage to protect himself, at some cost in income return, against
the possibility of adverse developments affecting his particular
property (such as a change in the character of the neighborhood).
It is within the province of sound insurance practice to afford
this protection in return for an adequate premium, provided of
course, that all phases of the business are prudently handled.
Such an arrangement will have the best chance of success if:

1. The mortgage loans are conservatively made in the first instance.

2. The guaranty or surety company is large, well managed, independent
of the agency selling the mortgages, and has a diversification of business in
fields other than real estate.

3. Economic conditions arc not undergoing fluctuations of abnormal
intensity.

The collapse in real estate values after 1929 was so extreme
as to contravene the third of these conditions. Accordingly
the behavior of real estate mortgage guarantees during this
period may not afford a really fair guide to their future value.
Nevertheless, some of the characteristics which they revealed are
worthy of comment.

This Business Once Conservatively Managed. —In the first
place a striking contrast may be drawn between the way in

220

FIXED-VALUE INVESTMENTS

221

which the business of guaranteeing mortgages had been conducted
prior to about 1924 and the lax methods which developed there¬
after, during the very time that this part of the financial field
was attaining its greatest importance.

If we consider the policies of the leading New York City
institutions which guaranteed real estate mortgages ( e.g. y Bond
and Mortgage Guarantee Company, Lawyers Mortgage Com¬
pany), it is fair to say that for many years the business was
conservatively managed. The amount of each mortgage was
limited to not more than 60% of the vaiue, carefully determined;
large individual mortgages were avoided; and a fair diversification
of risk, from the standpoint of location, was attained. It is true
that the guarantor companies were not independent of the selling
companies, nor did they have other types of surety business.
It is true also that the general practice of guaranteeing mortgages
due only three to five years after their issuance contained the
possibility, later realized, of a flood of maturing obligations at a
most inconvenient time. Nevertheless, the prudent conduct
of their activities had enabled them successfully to weather
severe real estate depressions such as occurred in 1908 and 1921.

New and Less Conservative Practices Developed. —The build¬
ing boom which developed during the “new era” was marked by
an enormous growth of the real estate mortgage business and
of the practice of guaranteeing obligations of this kind. New
people, new capital, and new methods entered the field. Several
small local concerns which had been in the field for a long period
were transformed into highly aggressive organizations doing a
gigantic and nation-wide business. Great emphasis was laid
upon the long record of success in the past, and the public was
duly impressed—not realizing that the size, the methods, and
the personnel were so changed that they were in fact dealing
with a different institution. In a previous chapter we pointed
out how recklessly unsound were the methods of financing real
estate ventures during this period. The weakness of the mort¬
gages themselves applied equally to the guarantees which were
frequently attached thereto for an extra consideration. The
guarantor companies were mere subsidiaries of the sellers of
the bonds. Hence, when the crash came, the value of the
properties, the real estate bond company, and the affiliated
guarantor company all collapsed together.

222

SECURITY ANALYSIS

Evil Effects of Competition and Contagion. —The rise of the
newer and more aggressive real estate bond organizations had
a most unfortunate effect upon the policies of the older concerns.
By force of competition they were led to relax their standards of
making loans. New mortgages were granted on an increasingly
liberal basis, and when old mortgages matured, they were
frequently renewed in a larger sum. Furthermore, the face
amount of the mortgages guaranteed rose to so high a multiple
of the capital of the guarantor companies that it should have
been obvious that the guaranty would afford only the flimsiest
of protection in the event of a general decline in values.

When the real estate market broke in 1931, the first conse¬
quence was the utter collapse of virtually every one of the newer
real estate bond companies and their subsidiary guarantor
concerns. As the depression continued, the older institutions
gave way also. The holders of guaranteed mortgages or partici¬
pations therein (aggregating about $3,000,000,000 guaranteed
by New York title and mortgage companies alone) found that the
guaranty was a mere name and that they were entirely dependent
upon the value of the underlying properties. In most cases these
had been mortgaged far more heavily than reasonable prudence
would have permitted. Apparently only a very small fraction
of the mortgages outstanding in 1932 were created under the
conservative conditions and principles that had ruled up to, say,
eight years previously.

Guarantees by Independent Surety Companies.—During the
1924-1930 period several of the independent surety and fidelity
companies extended their operations to include the guaranteeing
of real-estate mortgages for a fee or premium. Theoretically,
this should have represented the soundest method of conducting
such operations. In addition to the strength and general
experience of the surety company there was the important fact
that such a guarantor, being entirely independent, would pre¬
sumably be highly critical of the issues submitted for its guaranty.
But this theoretical advantage was offset to a great extent by
the fact that the surety companies began the practice of guar¬
anteeing real estate mortgage bonds only a short time prior to
their debacle, and they were led by the general overoptimism
then current to commit serious errors in judgment. In most
cases the resultant losses to the guarantor were greater than it

FIXED-VALUE INVESTMENTS

223

could stand; several of the companies were forced into receiver¬
ship (notably National Surety Company), and holders of bonds
with such guarantees failed to obtain full protection. 1

LEASEHOLD OBLIGATIONS EQUIVALENT TO GUARANTEES

The property of one company is often leased to another for a
fixed annual rental sufficient to pay interest and dividends on the
former's capital issues. Frequently the lease is accompanied
by a specific guaranty of such interest and dividend payments,
and in fact the majority of guaranteed corporate issues originate
in this fashion. 2 But even if there is no explicit guaranty, a
lease or other contract providing fixed annual payments will
supply the equivalent of a guaranty on the securities of the
lessee company.

Examples: An excellent instance of the value of such an
arrangement is afforded by the Westvaco Chlorine Products
Corporation 5,l£s, issued in 1927 and maturing in 1937. The
Westvaco Company agreed to sell part of its output to a sub¬
sidiary of Union Carbide and Carbon Corporation, and the latter
enterprise guaranteed that monthly payments would be made to
the trustee sufficient to take care of the interest and retirement
of the 5} ^ % bonds. In effect this arrangement was a guaranty
of interest and principal of the Westvaco issue by Union Carbide
and Carbon, a very strong concern. By reason of this protection
and the continuous purchases for redemption made thereunder,
the price of the issue was maintained at 99 or higher throughout
1932-1933. This contrasts with a decline in the price of West¬
vaco common stock from 1163/2 in 1929 to 3 in 1932. (The entire
bond issue was called at 100J^ in September 1935.)

1 But in the case of the independent surety companies the guarantees
proved of substantial, if only partial, value. The bankruptcy estate of
National Surety Company yielded a large cash payment to holders of bonds
bearing its guarantee. Some of the other companies managed to remain
solvent by affecting a kind of composition with bondholders, involving the
issuance of new bonds carrying a guarantee of interest at rather low rates,
though not of principal. Examples: Metropolitan Casualty Company,
Maryland Casualty Company, United States Fidelity and Guaranty
Company.

2 For example Pittsburgh, Fort Wayne and Chicago Railway Company
Preferred and Common receive 7 % dividends under a 999-year lease to the
Pennsylvania Railroad Company. These dividends are also guaranteed
by the Pennsylvania.

224

SECURITY ANALYSIS

Another interesting example is supplied by the Tobacco Prod¬
ucts Corporation of New Jersey 63^s, due 2022. The properties
of this company were leased to American Tobacco Company
under a 99-year contract, expiring also in 2022, providing for
annual payments of $2,500,000 (with the privilege to the lessee to
settle by a lump-sum payment equivalent to the then present
value of the rental, discounted at 7% per annum). By means of
a sinking-fund arrangement these rental payments were calcu¬
lated to be sufficient to retire the bond issue in full prior to
maturity, in addition to taking care of the interest. These
Tobacco Products 6^s were the equivalent of fixed obligations
of American Tobacco Company. As such they ranked ahead of
American Tobacco Preferred, dividends on which, of course, are
not a fixed charge. When the bonds were created in 1931 the
investing public was either sceptical of the validity of the lease
or—more probably—was not familiar with this situation, for
American Tobacco Preferred sold at a much higher relative price
than the Tobacco Products bonds. At the low price of 73 in 1932
the bonds yielded 8.90%, while American Tobacco preferred was
selling at 95, to yield 6.32%. In January 1935 the lease was
commuted by a lump-sum payment resulting in the redemption
of the Tobacco Products 6J<?s at par.

Specific Terms of Lease Important.— Example:

As in the case of guaranteed issues, the details of the lease
arrangement may have a vital bearing on the status of the issue
benefiting therefrom. Some of the elements here involved are
illustrated by the following example:

Georgia Midland Railway First 3s, due 1946. Not guaranteed,
but property leased to Southern Railway until 1995, at a
rental equal to present bond interest. (Price in January 1939,
35.)

In this case the lease agreement is fully equivalent to a guar¬
antee of interest up to and far beyond the maturity date. The
value of the guaranty itself depends upon the solvency of the
Southern Railway. The status of the bond issue at maturity in
1946 will depend, however, on a number of other factors as well,
e.g.:

1. The market value of a long-term rental obligation of South¬
ern Railway. If interest rates are low enough, and the credit of
Southern Railway high enough, the issue could be refunded at the

FIXED-VALUE INVESTMENTS

225

same 3 % interest rate into a longer maturity. (This would seem
far from probable in 1939.)

2. The value of the Georgia Midland mileage. If this mileage
actually earns substantially more than the rental paid, then
Southern Railway could be expected to make a special effort to
pay the bonds at maturity, for fear of otherwise losing control
of the property. This would involve an agreement to pay such
higher rental (i.e., interest rate) as may be necessary to permit
extension or refunding of the bond maturity. (However, traffic-
density data in private hands in 1939 indicated that this mileage
was not a valuable part of the Southern Railway System.)

3. Possible payment on grounds of convenience, etc. If the
Southern Railway is prosperous in ) 946, it may take care of this
maturity merely to avoid insolvency for part of the system.
•There is also the technical possibility that by the terms of its own
“ blanket” Development and General Mortgage (under which
sufficient bonds are reserved to refund the Georgia Midland 3s at
maturity), it may be considered to have an obligation to provide
for payment of these bonds in 1946. (Here also, as in the two
previous paragraphs, the bondholder in 1939 could not be too
confident of the strength of his position).

The foregoing discussion will perhaps adequately explain the
low price of the Georgia Midland 3s at the beginning of 1939.
It is interesting to note, as an element of security analysis, that
the key fact in this situation—the unprofitable character of the
mileage covered—was not a matter of public record but required
a check into supplementary sources of information.

Guaranteed Issues Frequently Undervalued.—The Tobacco
Products example illustrates the fairly frequent undervaluation
of guaranteed or quasi-guaranteed issues as compared with other
securities of the guarantor enterprise. A well-known instance
was that of San Antonio and Aransas Pass Railway Company
First 4s, due 1943, guaranteed as to principal and interest by
Southern Pacific Company. Although these enjoyed a mortgage
security in addition to the guaranty !.hey regularly sold at prices
yielding higher returns than did the unsecured obligations of the
Southern Pacific. 1

1 A. S. Dewing, in his A Study of Corporation Securities , pp. 293-297,
New York, 1934, makes the following statements with respect to guaranteed
bonds:

226

SECURITY ANALYSIS

Examples: A more striking contrast was afforded by the price
of Barnhart Bros, and Spindler Company First and Second

Comparative Prices and Yields of Guaranteed Securities and

Securities of the

Guarantor*

Issue

Date

San Antonio & Aransas Pass 1st 4s/1943

(GTD).

Jan. 2, 1920

8.30

Southern Pacific Co. Debenture 4s/1929.

Jan. 2, 1920

6.86

Barnhart Bros. & Spindler 7% 1st Ffd.

(GTD).

1923 low price

7.78

Barnhart Bros. & Spindler 7% 2d Pfd.

(GTD).

1923 low price

8.75

American Type Founders 7% Pfd.

1923 low price

7.37

Huyler's of Delaware 7% Pfd. (GTD)..

April 11, 1928

102%

6.83

Schulte Retail Stores 8% Pfd.

April 11, 1928

129

6.20

Armour of Delaware 7% P.d. (GTD)...

Feb. 13, 1925

95J 8 '

7.36

Armour of Illinois 7 % Ffd.

Feb. 13, 1925

92%

7.54

* If the reader traces the subsequent history of the various issues

in this table, he will

find a great variety of developments, including assumption through merger (San Antonio
and Aransas Pass Railroad), redemption (Barnhart Brothers and Spindler) and default
(Huylers of Delaware, Inc.). But the fact that the guaranteed issues were relatively under¬
valued is demonstrated by the sequel in each case.

" There may be, however, instances in which a holding or controlling
corporation will maintain the interest or rental on an unprofitable subsidi¬
ary's bonds for strategic reasons." (Here follow examples, including details
concerning San Antonio and Aransas Pass First 4s, due 1943, showing failure
of the issuer to earn its charges in most years.) "Yet its [San Antonio and
Aransas Pass Railway’s] importance to the Southern Pacific Company's
lines is such that the guarantor company very wisely meets the bond
interest deficit. ... In spite of such instances, the rule holds good almost
always that the strength of a guaranteed bond is no greater than that of the
corporation issuing it and the earning capacity of the property directly
covered by it."

It seems clear to us that these statements misinterpret the essential
character of the obligation under a guarantee. Southern Pacific met the
San Antonio and Aransas Pass bond interest deficit, not out of "wisdom"
but by compulsion. The strength of a guaranteed bond may be very much
greater than that of the corporation issuing it, because that strength rests
upon the dual claim of the holder against both the issuing corporation and
the guarantor.

FIXED-VALUE INVESTMENTS

227

Preferred (both guaranteed as to principal and dividends by
American Type Founders Company) in relation to the price of
the guarantor's own preferred stock which was not a fixed obliga¬
tion. Additional examples of this point are afforded by the
price of Huyler's of Delaware, Inc., Preferred, guaranteed by
Schulte Retail Stores Corporation, as compared with the price
of Schulte Preferred; and by the prh e of Armour and Company
of Delaware guaranteed preferred, as compared with the preferred
stock of the guarantor company, Armour and Company of
Illinois. Some comparative quotations relating to these examples
are given on page 226.

It is obvious that in cases of this sort advantageous exchanges
can be made from the lower yielding into the higher yielding
security with no impairment of safety; or else into a much better
secured issue with little sacrifice of yield, and sometimes with an
actual gain. 1

INCLUSION OF GUARANTEES AND RENTALS IN THE
CALCULATION OF FIXED CHARGES

All obligations equivalent to bond interest should be included
with a company’s interest charges when calculating the coverage
for its bond issues. This point has already been explained in
some detail in connection with railroad fixed charges, and it
was touched upon briefly in our discussion of public-utility bonds.
The procedure in these groups offers no special difficulties. But
in the case of certain types of industrial companies, the treat¬
ment of rentals and guarantees may offer confusing variations.
This question is of particular moment in connection with retail
enterprises, theater companies, etc., in which rent or other
obligations related to buildings occupied may be an important
element in the general picture. Such a building may be owned
by the corporation and paid for by a bond issue, in which case
the obligation will be fully disclosed in both the balance sheet
and the income account. But if another company occupies a
similar building under long-term lease, no separate measure of
the rental obligation appears in the income account and no

1 In Note 31 of the Appendix, p. 756, will be found a concise discussion of
certain interesting phases of guarantees and rentals, as illustrated by the
N.Y. and Harlem Railroad and the Mobile and Ohio Railroad situations.

228

SECURITY ANALYSIS

indication thereof can be found in the balance sheet. The
second company may appear sounder than the first, but that is
only because its obligations are undisclosed; essentially, both
companies are carrying a similar burden. Conversely, the out¬
right ownership of premises free and clear carries an important
advantage (from the standpoint of preferred stock, particularly)
over operation under long-term lease, although the capitalization
set-up will not reveal this advantage.

Examples: If Interstate Department Stores Preferred had
been compared with The Outlet Company Preferred in 1929
the two exhibits might have appeared closely similar; the earn¬
ings coverage averaged about the same, and neither company
showed any bond or mortgage liability. But Outlet’s position
was in actuality by far the stronger, because it owned its land
and buildings while those of Interstate (with a minor exception)
were held under lease. The real effect of this situation was to
place a substantial fixed obligation ahead of Interstate Depart¬
ment Stores Preferred which did not exist in the case of Outlet.
In the chain-store field a similar observation would apply to a
comparison of J. C. Penney Preferred and S. H. Kress Preferred
in 1932; for the latter company owned more than half of its
store properties, while nearly all the Penney locations were
leased.

Lease Liabilities Generally Overlooked.—The question of
liability under long-term leases received very little attention
from the financial world until its significance was brought home
rudely in 1931 and 1932, when the high level of rentals assumed
in the preceding boom years proved intolerably burdensome to
many merchandising companies.

Example: The influence of this factor upon a supposed invest¬
ment security is shown with striking force in the case of United
Cigar Stores Preferred. This issue, and its predecessor, had for
many years shown every sign of stability and had sold accordingly
at a consistently high level. For 1928 the company reported
“no funded debt” and earnings equal to about seven times the
preferred dividend. Yet so crushing were the liabilities under
its long-term leases (and to carry properties acquired by sub¬
sidiaries), that in 1932 bankruptcy was resorted to and the
preferred stock was menaced with extinction.

FIXED-VALUE INVESTMENTS

229

Such Liabilities Complicated Analysis. —It must be admitted
that in the case of companies where the rental factor is important,
its obtrusion has badly complicated the whole question of bond
or preferred stock analysis. Fortunately the investor now has
some data as to the extent of such leasehold obligations, since
they are now required to be summarized in registration state¬
ments filed with the S.E.C., and the actual rent payments must
be stated each year (on Form 10 K). 1 But the problem remains
whether or not these rentals should be treated, in whole or in part,
as the equivalent of fixed charges. To some extent, certainly,
they are identical rather with fixed “overhead”— e.g.j deprecia¬
tion, taxes, general expense—which it has not been found feasible
to add in with bond interest for the purpose of figuring a margin
of safety. One type of solution is obvious: If the company meets
the earnings test, even after adding rents paid to bond interest,
the rent situation need not worry the investor.

Example:

Swift and Company 3^4s> Dub 1950

1934-193S Average Results

Balance for dividends.S8,630,000

Interest paid. 2,107,000

Rentals paid. 996,000

Interest earned. 5.1 times

Interest and rentals earned.3.8 times

We feel, however, that it would be neither fair nor practicable
to require every company to meet a test so severe. A com¬
promise suggestion based on some study of actual exhibits may
be hazarded, viz.: (1) that one-third the annual rentals (for
building space) be included with fixed charges (and preferred
dividends), to compute the earnings coverage; and (2) that in the
case of retail establishments (chain stores, department stores)
the minimum coverage required for interest plus one-third of
rentals be reduced from 3 to 2. This reduction would recognize
the relative stability of retail business, after allowance is made
for the special burden attaching to the rental factor. The
corresponding coverage required for a retail company’s preferred
stock would be reduced from 4 to 2^-

1 The S.E.C. forms group “rents and royalties’' together, but in the
typical case this entire item relates to rents and can be treated as such.

230

SECURITY ANALYSIS

Examples:

(A) Nonretail Bond Issue
Loew's, Inc., 3J^s, Due 1946

August 1934-August 1938
Average Results

Balance for dividends.$10,097,000

Interest (and subsid. preferred dividends) paid. 2,614,000

One-third of rentals paid. ... . 1,107,000

Interest, etc., earned. 4 86 times

Interest and one-third of rentals earned . . .. 3.71 times

( B ) Retail Enterprise Preferred Stock

1934-1938 Average Results
McCrory Stores Corp. MeLcllan Stores Co.

Balance for common stock

Interest on bonds.

One-third of rentals.

Preferred dividends.

Preferred dividend (and in¬
terest earned) .

Preferred dividend, interest
and of rentals earned ..
* 1935-1938 average.

6 % Preferred
$1,682,000
abt. 200,000
770,000*
300,000

4.36 times

2.33 times

6 % Preferred
$1,148,000

434,000

180,000

7.38 times

2.87 times

Conclusions: Loew’s 3}^s pass our quantitative test for non¬
retail bond issues. McLellan Preferred does, but McCrory
Preferred does not, pass our suggested test for retail-store pre¬
ferred stocks.

The four preceding examples illustrate a simplified technique
for earnings coverage. Instead of first computing the amount
available for the charges, we divide the charges (and preferred
dividends) into the balance after charges (and preferred divi¬
dends) and add 1 to the quotient.

The reader is warned that these suggested standards and the
calculations illustrating them are submitted with considerable
hesitation. They represent a new departure in analytical
method; the data for rentals paid are available only at some
effort; most serious of all, the arithmetical standards proposed
are arbitrary and perhaps not the best that can be devised. We
might point out, further, that the new test may yield some
unexpected results. Note that McLellan Preferred has sold
(in 1939) at a lower price than McCrory Preferred—a point that
may be justified by other factors. Note, further, that if the same

FIXED-VALUE INVESTMENTS

231

calculation as above is applied to W. T. Grant 5% Preferred—a
high-priced issue, which earned its dividend nearly ten times over
in 1934—1938—we should find that the preferred dividend plus
one-third of rentals was covered not quite 2*^ times. 1

Status of Guaranteed Obligations.—Some additional observa¬
tions may properly be made as to the computation of earnings
coverage in the case of guaranteed obligations. In the typical
case the properties involved in the guarantee form part of the
whole enterprise; hence both the earnings therefrom and the
guaranteed payments are included in :;ingle income statement.

Example: Neisner Realty Corporation 6s, due 1948, are guar¬
anteed by Neisner Brothers, Inc. The corporation's operations
and interest charges are included in the parent company's
consolidated statement.

When the guaranteed security is outstanding against a sepa¬
rately operated property, its standing may depend either on its
own results or on those of the guarantor. Hence the issue need
be required to pass only one of three alternative tests, based on
(1) earnings of issuing company, independent of the guarantee,
or (2) combined earnings and charges of the issuing and guarantor
companies or (3) earnings of guarantor company applied to its
own charges plus its guarantees.

Examples: a. Indiana Harbor Belt Railway General 4s and
4J^s, due 1957. Guaranteed as to principal and interest by
New York Central Railroad and an important subsidiary. The
Standard Statistics Bond Guide gives as the interest coverage
that of the guarantor, the New York Central System. But the
showing of the company itself is much better, e.g.:

b. This is the typical situation, in which coverage is calculated
from a consolidated income account, including operations of
1 This stock, par 20, sold at 25 in 1939 although callable at 22.

232

SECURITY ANALYSIS

both the parent (guarantor) company and its guaranteed
subsidiaries.

c. Minneapolis, St. Paul and Sault Sainte Marie 53^s, due
1978, guaranteed as to interest by Canadian Pacific Railway.
The “Soo line” shows earnings of only a small part of total
interest charges. Coverage for this issue might best be computed
by applying earnings of Canadian Pacific Railway to the total
of its own interest charges plus the guaranteed interest on these
and other bonds guaranteed by Canadian Pacific Railway.

SUBSIDIARY COMPANY BONDS

The bonds of a subsidiary of a strong company are generally
regarded as well protected, on the theory that the parent company
will take care of all its constituents' obligations. This viewpoint
is encouraged by the common method of setting up consolidated
income accounts, under which all the subsidiary bond interest
appears as a charge against all the combined earnings, ranking
ahead of the parent company's preferred and common stocks.
If, however, the parent concern is not contractually responsible
for the subsidiary bonds, by guaranty or lease (or direct assump¬
tion), this form of statement may prove to be misleading. For
if a particular subsidiary proves unprofitable, its bond interest
may conceivably not be taken care of by the parent company,
which may be willing to lose its investment in this part of its
business and turn it over to the subsidiary's bondholders. Such
a development is unusual, but the possibility thereof was forcibly
demonstrated in 1932-1933 by the history of United Drug
Company 5s, due 1953.

Examples: United Drug was an important subsidiary of Drug,
Inc., which had regularly earned and paid large dividends, gained
chiefly from the manufacture of proprietary medicines and other
drugs. In the first half of 1932, the consolidated income account
showed earnings equal to ten times the interest on United Drug
5s, and the record of previous years was even better. While
this issue was not assumed or guaranteed by Drug, Inc., investors
considered the combined showing so favorable as to assure the
safety of the United Drug 5s beyond question. But United Drug
owned, as part of its assets and business, the stock of Louis K.
Liggett Company, which operated a large number of drug stores
and which was burdened by a high-rental problem similar to

FIXED-VALUE INVESTMENTS

233

that of United Cigar Stores. In September 1932 Liggett’s
notified its landlords that unless rents were reduced it would be
forced into bankruptcy.

This announcement brought rudely home to investors the fact
that the still prosperous Drug, Inc., was not assuming responsi¬
bility for the liabilities of its (indirect) subsidiary, Liggett’s, and
they immediately became nervously conscious of the fact that
Drug, Inc., was not responsible for interest payments on United
Drug 5s either. Sales of these bonds resulting from this discovery
depressed the price from 93 earlier in tne year down to 42. At
the latter figure, the $40,000,000 of United Drug 5s were quoted
at only $17,000,000, although the parent company’s stock was
still selling for more than $100,000,000 (3,500,000 shares at about
30). In the following year the “Drug, Inc., System” was
voluntarily dissolved into its component parts—an unusual
development—and the United Drug Co. resumed its entirely
separate existence. (It has since shown an inadequate coverage
for the 5% bonds.)

Consolidated Traction Company of New Jersey First 5s were
obligations of a large but unprofitable subsidiary of Public
Service Corporation of New Jersey. The bonds were not guar¬
anteed by the parent company. When they matured in 1933
many of the holders accepted an offer of 65 for their bonds made
by the parent company.

Saltex Looms, Inc., 1st 6s, due 1954, were obligations of a
subsidiary of Sidney Blumenlhal & Co., Inc., but in no way
guaranteed by the parent company. The consolidated earning
statements of Blumenthal regularly deducted the Saltex bond
interest before showing the amount available for its own pre¬
ferred stock. Interest on the bonds was defaulted, however, in
1939; and in 1940 the bonds sold at 7 while Blumenthal preferred
was quoted above 70.

Separate Analysis of Subsidiary Interest Coverage Essential.—

These examples suggest that just as investors are prone to under¬
estimate the value of a guaranty by a strong company, they
sometimes make the opposite mistake and attach undue signifi¬
cance to the fact that a company is controlled by another. From
the standpoint of fixed-value investment, nothing of importance
may be taken for granted. Hence a subsidiary bond should
not be purchased on the basis of the showing of its parent com-

234

SECURITY ANALYSIS

pany, unless the latter has assumed direct responsibility for the
bond in question. In other cases the exhibit of the subsidiary
itself can afford the only basis for the acceptance of its bond
issues. 1

If the above discussion is compared with that on page 177, it
will be seen that investors in bonds of a holding company must
insist upon a consolidated income account, in which the sub¬
sidiary interest—whether guaranteed or not—is shown as a
prior charge; but that purchasers of unguaranteed subsidiary
bonds cannot accept such consolidated reports as a measure
of their safety, and must require a statement covering the
subsidiary alone. These statements may be obtainable only
with some difficulty, as was true in the case of United Drug 5s,
but they must nevertheless be insisted upon.

1 As a practical matter, the financial interest of the parent company in its
subsidiary, and other business reasons, may result in its protecting the
latter’s bonds even though it is not obligated to do so. This would be
a valid consideration, however, only in deciding upon a purchase on a
speculative basis (i.e., carrying a chance of principal profit), but would not
justify buying the bond at a full investment price. Concretely stated, it
might have made United Drug 5s an excellent speculation at 45, but they
were a poor investment at 93.

CHAPTER XVIII

PROTECTIVE COVENANTS AND REMEDIES OF
SENIOR SECURITY HOLDERS

In this and the two succeeding chapters we shall consider the
provisions usually made to protect the rights of bond owners and
preferred stockholders against impairment, and the various lines
of action which may be followed in the event of nonfulfillment of
the company’s obligations. Our object here, as throughout this
book, is not to supply information of a kind readily available
elsewhere, but rather to subject current practices to critical
examination and to suggest feasible improvements therein for
the benefit of security holders generally. In this connection a
review of recent developments in the field of reorganization
procedure may also be found of value.

Indenture or Charter Provisions Designed to Protect Holder
of Senior Securities. —The contract between a corporation and
the owners of its bonds is contained in a document called the
indenture or deed of trust . The corresponding agreements relating
to the rights of preferred stockholders are set forth in the Articles,
or Certificate, of Incorporation. These instruments usually
contain provisions designed to prevent corporate acts injurious
to senior security holders and to afford remedies in case of certain
unfavorable developments. The more important occurrences
for which such provision is almost always made may be listed
under the following heads:

1. In the case of bonds:

a. Nonpayment of interest, principal, or sinking fund.

b. Default on other obligations, or receivership.

c. Issuance of new secured debt.

d . Dilution of a conversion (or subscription) privilege.

2. In the case of preferred stocks:

а. Nonpayment of (cumulative) preferred dividends for a period of
time.

б. Creation of funded debt or a prior stock issue.

c. Dilution of a conversion (or subscription) privilege.

235

236

SECURITY ANALYSIS

A frequent, but less general, provision requires the maintenance
of working capital at a certain percentage of the bonded debt
of industrial companies. (In the case of investment-trust or
holding-company bonds it is the market value of all the assets
which is subject to this provision.)

The remedies provided for bondholders in cases falling under
la and 16 above are fairly well standardized. Any one of these
untoward developments is designated as an “event of default”
and permits the trustee to declare the principal of the bond issue
due and payable in advance of the specified maturity date. The
provisions therefor in the indenture are known as “ acceleration
clauses.” Their purpose in the main is to enable the bondholders
to assert the full amount of their claim in competition with the
other creditors.

Contradictory Aspects of Bondholders’ Legal Rights. —In con¬
sidering these provisions from a critical standpoint, we must
recognize that there are contradictory aspects to the question
of the bondholders’ legal rights. Receivership 1 is a dreaded word
in Wall Street; its advent means ordinarily a drastic shrinkage
in the price of all the company’s securities, including the bonds
for the “benefit” of which the receivership was instituted. As
we pointed out in a former chapter, the market’s appraisal of a
bond in default is no higher on the whole, and perhaps lower, than
that of a non-dividend-paying preferred stock of a solvent
company.

The question arises, therefore, whether the bondholders might
not be better off if they did not have any enforceable claim to
principal or interest payments when conditions are such as to
make prompt payment impossible . For at such times the bond¬
holder’s legal rights apparently succeed only in ruining the

1 * 1 Receivership ’ 9 was formerly a convenient term, applying to all kinds
of financial difficulties that involved court action. As a result of the
Chandler Act (Bankruptcy Act of 1938), receivers have been largely replaced
by trustees. No doubt the word receivership will continue to be used—
for a while at least—because the terms “trusteeship” and “bankruptcy”
are not quite satisfactory, the former being somewhat ambiguous, the
latter having an ovcrdrastic connotation. “Insolvency” is a suitable
word but awkward to use at times.

So-called “equity receivers” will still be appointed in the future in
connection with stockholder's suits, voluntary liquidations and other
special matters.

FIXED-VALUE INVESTMENTS

237

corporation without benefiting the bondholder. As long as
the interest or principal is not going to be paid anyway, would
it not be to the interest of the bondholders themselves to
postpone the date of payment *and keep the enterprise out of the
courts?

Corporate Insolvency and Reorganization—This question
leads into the broad field of corporate insolvency and reorganiza¬
tion. We must try, within as brief a space as possible, first, to
describe the procedure followed prior to the amendatory legisla¬
tion beginning in 1933; secondly, to summarize the changes
brought about by the recent statutes; and, finally, to evaluate
the bondholder’s position as it now appears. (The latter will be
especially difficult, since the new laws have not yet had time to
prove their merits or deficiencies in actual practice.)

The old pattern for corporate reorganization went usually as
follows: Inability to pay interest or principal of indebtedness led
to an application by the corporation itself for a receiver. 1 It was
customary to select a “friendly” court; the receiver was generally
the company’s president; the bondholder interests were repre¬
sented by protective committees ordinarily formed by the
investment banking houses that had floated the issues. A
reorganization plan was agreed upon by the committees and then
approved by the court. The plan usually represented a com¬
promise of the conflicting interests of the various ranks of security
holders, under which, generally speaking, everyone retained some
interest in the new company and everyone made some sacrifice.
(In numerous cases, however, small and well-entrenched issues
at the top were paid off or left undisturbed; and in hopeless
situations stock issues were sometimes completely wiped out.)
The actual mechanics of reorganization was through a fore¬
closure or bankruptcy sale. The properties were bought in in
behalf of the assenting securityholders; and creditors who
refused to participate received in cash their pro rata share, if any,
of the sale price. This price was usually set so low that everyone
was better off to join in the plan and take new securities rather
than to stay out and take cash.

1 Other “events of default failure tc meet sinking-fund or working-

capital requirements—rarely resulted in receivership. Almost always
bondholders preferred to overlook, or negotiate over, these matters rather
than harm themselves by throwing the company in the courts.

238

SECURITY ANALYSIS

Between 1933 and 1939 this procedure was completely trans¬
formed by a series of remedial laws, the most important of which
was the Chandler Act. The defects for which a cure was desired
were of two kinds: On the one hand the necessity for paying
nonassenting bondholders had developed into a dilemma;
because unduly low “upset,” or minimum, foreclosure-sale
prices were being frowned on by the courts, whereas payment
of a fair price involved often an insuperable problem of finding
the cash. More serious was the fact that the whole mechanics
of reorganization tended to keep complete dominance of the
situation in the hands of the old controlling group—who may
have been inefficient or even dishonest, and who certainly had
special interests to serve.

Beginning with the 1933 changes, a reorganization technique
was set up under which a plan accepted by two-thirds of the
creditors and a majority of the stockholders (if they had some
“equity”), and approved by the court, was made binding on all
the security holders. This has done away with the cumbersome
and otherwise objectionable device of the foreclosure sale. As
perfected by the Chandler Act and the Trust Indenture Act of
1939, the new procedure for other than railroad companies
includes the following additional important points: 1

1. The company must be turned over to at least one disinter¬
ested trustee. This trustee must decide whether any claims
should be asserted against the old management and also whether
or not the business is worth continuing.

2. Actual responsibility for devising a reorganization plan
devolves on three disinterested agencies: (1) the trustee, who must
present the plan in the first instance; (2) the S.E.C. (when the
liabilities exceed $3,000,000), who may submit an advisory
opinion thereon; (3) and the judge, who must officially approve it.

1 Provisions 1 to 4 appear in Chap. X of the Chandler Act, an outgrowth
of the famous Sec. 77B, which was added to the old bankruptcy act in
1933. Railroad reorganizations arc governed by Sec. 77, which was
carried over into the Chandler Act intact, and by Chap. XV, added in
1939 (see below, p. 245). There is also a Chap. XI proceeding under the
Chandler Act, relating to “arrangements” of unsecured indebtedness only.
Note resort to such proceedings by Haytian Corporation in 1938 and by
United States Realty and Improvement Company in 1939. In the latter
case the only matter affected was its guarantee of Trinity Buildings Corpo¬
ration 5}£s, the company seeking to keep its own structure unchanged.
Difficulties developed, and the proceedings were replaced by others.

FIXED-VALUE INVESTMENTS

239

Although the security holders and their protective committees
may make suggestions, their acceptance is not asked for until the
disinterested agencies have done their work. Furthermore,
apparently wide powers are now given the court to force accept¬
ance upon classes of holders who have failed to approve in the
requisite percentage; but the exact ext< nt of these powers is still
uncertain.

3. The reorganization plan must meet a number of standards
of fairness prescribed in the statute, including provisions relating
to voting power, publication of report, etc. The court must
specifically approve the new management.

4. The activities of protective committees are subject to close
scrutiny and supervision. Reorganization costs of all kinds,
including compensation to all and sundry, must receive court
sanction.

5. As distinct from reorganization procedure proper, the Trust
Indenture Act prescribes a number of requirements for trustees
acting under bond indentures. These are designed both to
obviate certain conflicts in interest that have caused considerable
complaint and also to insure a more active attitude by the trustee
in behalf of the bondholders.

There is no doubt at all in our minds that in the typical case the
recent legislation 1 will prove highly beneficial. It should elimi¬
nate a number of the abuses formerly attaching to receiverships
and reorganizations. It should also speed up materially the
readjustment process. This should be true, especially, after more
definite standards of fairness in reorganization plans have come
to be established, so that there will not be so much room as
heretofore for protracted disputes between the different ranks
of security holders. 2

1 Legislation analogous to the mechanics of the 77B and Chandler Act
provisions was applied to real estate readjustments in the Schackno and
Burchill Acts passed by the New York State Legislature in 1933. In the
same year The Companies’ Creditors Arrangement Act, adopted in Canada,
provided that insolvent Canadian Companies might escape proceedings
under the Bankruptcy Act and work out compromises with creditors with
the sanction of the court. When properly approved, such compromises are
binding on minority groups. See W. S. Lightball, The Dominion Companies
Act 1934, annotated , pp. 289, 345 ff Montreal, 1935.

2 The tendency of the S.E.C. advisory opinions, as well as the findings of
the I.C.C. in railroad reorganizations, has been strongly in the direction of

240

SECURITY ANALYSIS

Alternative Remedy Suggested .—Despite these undoubted
reforms in reorganization technique, we shall be bold enough to
venture the assertion that the ideal protective procedure for
bondholders may often be found along other and simpler lines.
In our opinion—given a sufficiently simple debt structure—the
best remedy for all injuries suffered by bondholders is the imme¬
diate vesting in them of voting control over the corporation,
together with an adequate mechanism to assure the intelligent
exercise of such control. In many cases the creditors would then
be able to marshal the company's resources and earnings for their
own protection in such a way as to avoid recourse to expensive
and protracted judicial proceedings.

Our suggestion falls into two parts: First, voting control by
bondholders would, by the terms of the indenture, constitute the
sole immediate remedy for any event of default, including non¬
payment of interest or principal. During such control, unpaid
interest or principal would be considered subject to a grace
period. But the directors representing the bondholders should
have the right to apply for a trusteeship under the Chandler Act,
if they feel that comprehensive reorganization is preferable to an
indefinite continuance of the moratorium plus control. Secondly,
this voting control could best be implemented through the
indenture trustee—a large and financially experienced institution,
which is competent to represent the bondholders generally and to
recommend to them suitable candidates for the controlling direc¬
torships. Stockholder's interests should continue to be repre¬
sented on the board by minority directors.

What this arrangement would mean in effect is the turning of
a fixed-interest bond into an income bond during the period of
bondholders' control; and the postponement of maturing debt
until voluntary extension or refinancing becomes feasible or else

eliminating stockholders when there appears to be no chance that earnings
will cover former interest charges. For a discussion of this point by one of
the authors, see Benjamin Graham, “Fair Reorganization Plans under
Chapter X of the Chandler Act,” Brooklyn Law Review , December 1938.

Despite the improvements in the law, railroad reorganizations have
been subject to extraordinary delays since 1933. In our opinion, however,
this was due not so much to weaknesses remaining in the statute as it was to
the extraordinary problem of devising fair plans for extremely complicated
corporate structures when the question of future earning power was both
highly controversial and of critical importance.

FIXED-VALUE INVESTMENTS

241

until liquidation or sale is found to be the desirable course. It
should also be feasible to extend the basic technique and principle
of voluntary recapitalization by statute (now applying only to the
various stock issues) to include a bond issue as well, when the
plan emanates from bondholders’ representatives who have
the alternative of keeping control and merely waiting.

Obviously, however, control cannot well be vested in creditors
when they belong to several classes with conflicting interests.
In such cases Chandler Act proceedings would seem necessary
to cut the Gordian knot. But, theoretically at least, a voting-
control arrangement is possible with a simple senior and a simple
junior lien. If default should occur only with .respect to the
junior lien, voting control would pass to that issue. If the senior
lien is defaulted, it would take control as a single class.

Although these suggestions may inspire doubt because of their
novelty, it should be pointed out that the idea of voting by bond¬
holders is both an old one and growing in vogue. Although in the
past it was an exceptional arrangement, we now find that many
reorganization plans, providing for issuance of income bonds,
give voting powers to these securities, generally calling for control
of the board of directors until all or most of the issue is retired or
if interest is not paid in full. 1 Furthermore, many indentures
covering fixed-interest bonds now provide for a vote by bond¬
holders on amendments to the indenture. 2 It is also common for

1 Examples: The reorganization plan of New York State Railways (Syra¬
cuse System), dated February 1939, provides that the holders of the new
income notes shall be entitled to elect two-thirds of the directors until at
least 80% of the notes have been retired. Commercial Mackay Cor¬
poration Income Debentures, due 1967, elect one-third of the directors until
all bonds are retired.

National Hotel of Cuba Income 6s, due 1959 (issued in 1929), were given
voting control in the event of default of one year’s interest. Older examples
of voting rights given to bondholders include Erie Railroad Prior Lien 4s
and General 4s, Mobile and Ohio Railroad General 4s, Third Avenue
Railway Adjustment 5&.

The 1934 reorganization of Maple Leaf Milling Company, Ltd. (Canada),
provided that the Indenture Trustee of the 5}^s due 1949 (later extended
to 1958) would exercise effective control of the company by ownership (in
trust) of 2 out of 3 management or voting shares.

1 Generally excluded from this provision are changes in maturity dates of
principal or interest, the rate of interest, the redemption price and the con¬
version rate. Examples: Richfield Oil Corporation Debenture 4s, due

242

SECURITY ANALYSIS

Canadian trust indentures to provide for meetings of bondholders
in order to amend the terms of the indenture, including even the
postponement or change of interest or principal payments. 1
Such meetings may be called by the trustee, by a stated propor¬
tion of the bondholders, or in certain instances by the company
itself.

It may be objected that the suggested arrangement would
really give a bondholder no better legal rights than a preferred
stockholder and would thus relegate him to the unsatisfactory
position of having both a limited interest and an unenforceable
claim. Our answer must be that, if the control device can be
developed properly, it would provide an adequate remedy for
both bondholders and preferred stockholders. In that case the
basic contractual advantage of bonds over prefered shares would
vanish, except to the extent of the right of bonds to repayment at
a fixed date. We repeat, in conclusion, the point made in our
discussion of the theory of preferred stocks (page 189),
that the contractual disadvantage of preferred shares is, at
bottom, not so much a matter of inherent legal rights as
it is of practical corporate procedure and of the investor’s own
shortcomings.

Tendency of Securities of Insolvent Companies to Sell below
Their Fair Value.—Some additional aspects of the corporate-
reorganization question deserve attention. The first relates to
the market action of securities of insolvent companies. Receiver¬
ships in the past have been productive generally of a vast and
pervasive uncertainty, which threatens extinction to the stock¬
holders but fails to promise anything specific to the bondholders.
As a result there has been a tendency for the securities of com¬
panies in receivership to sell below their fair value in the
aggregate; and also a tendency for illogical relationships to be
established between the price of a bond issue in default and the
price of the junior stock issues.

1952. The Industrial Rayon First 4}£s, duo 1948, are unusual in that the
indenture permits a two-thirds vote of bondholders to postpone interest
payments. However, the New York Stock Exchange required an under¬
taking not to invoke this clause, as a condition of listing the issue.

1 See the S.E.C. Report on the Study and Investigation of the Work, Activi¬
ties, Personnel and Functions of Protective and Reorganization Committees ,
Pt. VI, pp. 135-177, especially pp. 13S-143, 164-177, Washington, 1936.

FIXED-VALUE INVESTMENTS

243

Examples: The Fisk Rubber Company case is an excellent
example of the former point; the Studebaker Corporation situa¬
tion in September 1933 illustrates the latter.

Market Value op Fisk Rubber Securities in April 1932

$7,600,000 First 8s @ 16. $ 1,200,000

8,200,000 Debenture 5}^>8 @11. 900,000

Stock issues. Nominal

Total market value of the company. $ 2,100,000

Balance Sheet, June 30, 1932

Cash. $ 7,687,000

Receivables (less reserve of $1,425,000). 4,838,000

Inventories (at lower of cost or market). 3,216,000

$157741,000

Accounts Payable. 363,000

Net current assets. $15,378,000

Fixed assets (less $8,400,000 depreciation). 23,350,000

The company’s securities were selling together for less than
one-third of the cash alone, and for only one-seventh of the net
current assets, allowing nothing for the fixed property. 1

Studebaker Corporation, September 1933

Issue

Face

amount

Market

price

Market

value

10-year 6% notes and other claims.

$22,000,000

$ 8,800,000

Preferred stock.

5,800,000

$ 1,500,000

Common stock (2,464,000 shares).

Total value of stock issues.

14,700,000

$16,200,000

The company’s debt, selling at 40 cents on the dollar, was
entitled to prompt payment in full before the stockholder received
anything. Nevertheless, the market placed a much larger value
upon the stock issues than upon the prior debt.

Voluntary Readjustment Plans.—Realization of the manifest
disadvantages of receivership has often led bondholders to accept
suggestions emanating from the management for a voluntary
reduction of their contractual claims. Arrangements of this

1 As pointed out in Chap. L, below, the Fisk Rubber 8a later proved to
be worth close to 100 and the 5Ms more than 70.

244

SECURITY ANALYSIS

kind have varied from the old-fashioned type of “composition”
(in which creditors extended or even curtailed their claims, while
the stockholders retained their interest intact) to cases where the
bondholders received a substantial part of the stock equity.

Examples: At the end of 1931 Radio-Keith-Orpheum Corpora¬
tion, needing funds to meet pressing obligations, found ordinary
financing impossible. The stockholders ratified a plan under
which in effect they surrendered 75% of their stock interest,
which was given in turn as a bonus to those who supplied the
$11,600,000 required by purchasing debenture notes. (Con¬
tinued large losses, however, forced the company into receivership
a year later.)

In 1933 Fox Film Corporation effected a recapitalization of
the same general type. The stockholders gave up over 80%
of their holdings, and this stock was in turn exchanged for
nearly all of approximately $40,000,000 of 5-ycar notes and
bank debt.

The Kansas City Public Service Company readjustment plan,
also consummated in 1933, was designed to meet the simpler
problem of reducing interest charges during a supposedly tempo¬
rary period of subnormal earnings. It provided that the coupon
rate on the 6% first-mortgage bonds should be reduced to 3%
during the four years 1933-1936, restored to 6% for 1937-1938,
and advanced to 7% for 1939-1951, thus making up the 12%
foregone in the earlier years. A substantial sinking fund,
contingent upon earnings, was set up to retire the issue gradually
and to improve its market position.

It was obvious that the Kansas City Public Service bondholders
were better off to accept temporarily the 3% which could be
paid rather than to insist on 6% which could not be paid and
thereby precipitate a receivership. (The previous receivership
of the enterprise, terminated in 1926, had lasted six years.) In
this case the stockholders were not required to give up any part
of their junior interest to the bondholders in return for the
concessions made. While theoretically some such sacrifice and
transfer would be equitable, it was not of much practical impor¬
tance here because any stock bonus given to the bondholders
would have had a very slight market value. 1 It should be

1 In 1936 the company effected a second voluntary rearrangement,
under which the interest rate was fixed at 4 %, and the bondholders received

FIXED-VALUE INVESTMENTS

245

recognized as a principle, however, that the waiving of any
important right by the bondholders entitles them to some quid
pro quo from the stockholders—in the form either of a contribu¬
tion of cash to the enterprise* or of a transfer of some part of
their claim on future earnings to the bondholders. 1

In 1939 additional legislation of a temporary nature was
adopted, designed to facilitate so-called “voluntary reorganiza¬
tions^ of railroads by making them binding on all security
holders. 2 This statute was intended specifically to aid the
Baltimore and Ohio and Lehigh Valley roads, which had pre¬
viously proposed voluntary reorganization plans. These were
designed to reduce fixed-interest charges and to extend current
and near maturities. The stockholders, in each case, were to
retain their interests intact.

As we have previously stated, it is our opinion that voluntary
readjustment plans are desirable in themselves, but they should
be proposed after voting control over the corporation has passed
to the bondholders, and they are in a position to choose between
alternative courses of action.

Change in the Status of Bond Trustees.—Not the least impor¬
tant of the remedial legislation enacted since 1933 is the “Trust
Indenture Act of 1939.” This undertakes to correct a number
of inadequacies and abuses in the administration of their duties

a rather nugatory bonus of common stock. In 1939 still a third voluntary
modification was accepted, in which bondholders took 30% in cash and
70% in preferred stock for their bonds—the money being advanced as a
loan by the R.F.C.

1 The reorganization of Industrial Office Building Company in 1932-1933
is a remarkable example of the conversion of fixed-interest bonds into income
bonds without sacrifice of any kind by the stockholders. A detailed dis¬
cussion of this instance is given in the Appendix Note 32, p. 757.

2 This is the Chandler Railroad Readjustment Act of 1939, which actually
adds a new Chap. XV to the Bankruptcy Act. Action thereunder must be
begun before July 31, 1940, and must be substantially concluded within a
year after its initiation. As far as the reorganization technique is con¬
cerned, it is not significantly different from that provided in Section 77.
In both cases approval of the I.C.C., of a court and of a suitable percentage
of security holders is required. The important difference is that under the
new Chap. XV there is no bankruptcy in the involved legal sense. The
company continues to administer its own affairs, and no contracts or
other obligations are affected except those specifically included in the plan
of readjustment.

246

SECURITY ANALYSIS

by bond trustees. The chief criticism of the behavior of inden¬
ture trustees in the past is that they did not act as trustees ai
all but merely as agents of the bondholders. This meant that
as a general rule they took no action on their own initiative but
only when directed to do so and were fully indemnified by a
certain percentage of the bondholders. 1 Indentures have said
practically nothing about the duties of a trustee but a great deal
about his immunities and indemnification.

The 1939 statute aims directly at this unsatisfactory situation
by including the following provision (in Section 315):

Duties of the Trustee in Case of Default

(c) The indenture to be qualified shall contain provisions requiring
the indenture trustee to exercise in case of default (as such term is
defined in the indenture) such of the rights and powers vested in it by
such indenture, and to use the same degree of care and skill in their
exercise, as a prudent man would exercise or use under the circum¬
stances in the conduct of his own affairs.

There are further provisions limiting the use of so-called
exculpatory clauses, which in the past made it impossible to
hold a trustee to account for anything except provable fraud or
else negligence so gross as to be equivalent thereto.

A further cause of complaint arose from the fact that the
indenture trustee has frequently been a creditor of the obligor
(e.g.y a trust company holding its promissory notes) or else has
been controlled by the same interests. These situations have
created conflicts of interest, or an unwillingness to act impar¬
tially and vigorously, which have militated strongly against the
bondholders. The Trust Indenture Act of 1939 contains
stringent provisions designed to terminate these abuses. 2

The Problem of the Protective Committee. —Reform in the
status of indenture trustees may lead to a solution of the vexing

1 See Appendix Note 33, p. 759, for further discussion and an example on
this point appearing in the first edition of this work.

* The remedial legislation was an outgrowth of a trust indenture study
made by the S.E.C. and was greatly stimulated by the opinion delivered by
Judge Rosenman in 1936 denying the claims of holders of National Electric
Power (secured) debentures to hold the trustee of the issue accountable for
the huge losses suffered by them. The judge held that the exculpatory
clauses saved the trustee in this case but that the whole system of indenture
trusteeship was in need of radical reform.

FIXED-VALVE INVESTMENTS

247

problem of the protective committee. Since 1929 the general
status of protective committees has become uncertain and most
unsatisfactory. Formerly it was taken for granted that the
investment bankers who floated the issue would organize a pro¬
tective committee in the event of default. Eut in recent years
there has been a growing tendency to question the propriety or
desirability of such action. Bondholders may lack faith in the
judgment of the issuing house, or they may question its ability
to represent them impartially because of other interests in or
connections with the enterprise; or tin./ may even consider the
underwriters as legally responsible for the losses incurred. The
arguments in favor of competent representation by agencies other
than the houses of issue arc therefore quite convincing. The
difficulty lies however, in securing such competent represen¬
tation. With the original issuing houses out of the picture,
anybody can announce himself as chairman of a protective com¬
mittee and invite deposits. The w T hole procedure has become
unstandardized and open to serious abuses. Duplicate com¬
mittees often appear; an undignified scramble for deposits takes
place; persons with undesirable reputations and motives can
easily inject themselves into the situation.

The new bankruptcy legislation of 1938 introduced some
improvement into this situation by subjecting the activities and
compensation of protective committees to court scrutiny. (In
the case of railroads a committee cannot take part in a pro¬
ceeding without prior permission from the I.C.C.) Further
legislation will probably be enacted regulating in more detail
the formation as well as the subsequent conduct of protective
committees.

A Recommended Reform.—The w r hole procedure might
readily be clarified and standardized now that the trustee under
the indenture is expected to assume the duty of actively pro¬
tecting the bond issue. The large institutions which hold these
positions have the facilities, the experience and the standing
required for the successful discharge of such a function. There
seems no good reason, in the ordinary case, why the trustee
should not itself organize the protective committee, with one of
its executive officers as chairman and with the other members
selected from among the larger bondholders or their nominees.
The possible conflict of interest between the trustee as represen-

248

SECURITY ANALYSIS

tative of all the bondholders and the protective committee as
representative of the depositing holders only will be found on
analysis rarely to be of more than technical and minor con¬
sequence. Such a conflict, if it should arise, could be solved by
submission of the question to the court. There is no difficulty
about awarding sufficient compensation to the trustee and its
counsel for their labors and accomplishment on behalf of the
bondholders.

This arrangement envisages effective cooperation between the
trustee and a group of bondholders who in the opinion of the
trustee are qualified to represent the issue as a whole. The best
arrangement might be to establish this bondholders’ group at
the time the issue is sold, i.e., without waiting for an event of
default to bring it into being, in order that there may be from
the very start some responsible and interested agency to follow
the affairs of the corporation from the bondholders’ standpoint,
and to make objections, if need be, to policies which may appear
to threaten the safety of the issue. Reasonable compensation
for this service should be paid by the corporation. This would
be equivalent in part to representation of the bondholders on
the board of directors. If the time were to arrive when the
group would have to act as a protective committee on behalf
of the bondholders, their familiarity with the company’s affairs
should prove of advantage.

CHAPTER XIX

PROTECTIVE COVENANTS (( Continued)

Prohibition of Prior Liens.—A brief discussion is desirable
regarding certain protective provisions other than those dealing
with the ordinary events of default. (The matter of safeguarding
conversion and other participating privileges against dilution
will be covered in the chapters dealing with Senior Securities
with Speculative Features.) Dealing first with mortgage bonds,
we find that indentures almost always prohibit the placing of
any new prior lien on the property. Exceptions are sometimes
made in the case of bonds issued under a reorganization plan,
when it is recognized that a prior mortgage may be necessary
to permit raising new capital in the future.

Example: In 1926 Chicago, Milwaukee, St. Paul and Pacific
Railroad Company issued $107,000,000 of Series A Mortgage
5% bonds and, junior thereto, $185,000,000 of Convertible
Adjustment Mortgage 5s, in exchange for securities of the bank¬
rupt Chicago, Milwaukee and St. Paul Railway Company. The
indentures permitted the later issuance of an indefinite amount
of First and Refunding Mortgage Bonds, which would rank ahead
of the Series A Mortgage 5s. 1

Equal-and-ratable Security Clause. —When a bond issue is
unsecured it is almost always provided that it will share equally
in any mortgage lien later placed on the property.

Example: The New York, New Haven and Hartford Railroad
Company sold a number of debenture issues between 1897 and
1908. These bonds were originally unsecured, but the indentures
provided that they should be equally secured with any mortgage
subsequently placed upon the property. In 1920 a first and
refunding mortgage was authorized by the stockholders; con¬
sequently the earlier issues have since been equally secured with

1 In 1933 the St. Paul was granted permission to issue some of the new
first and refunding bonds, to be held as collateral for short-term loans made
by the United States government.

249

250

SECURITY ANALYSIS

bonds issued under the new mortgage. They still carry the
title of “ debentures/ 1 but this is now a misnomer. There is,
however, an issue of 4% debentures, due in 1957, which did not
carry this provision and hence are unsecured. In 1939 the
(unsecured) debenture 4s, due 1957, sold at one-third the price
of the (secured) debenture 4s, due 1956, e.g., 5 vs. 16. 1

Purchase-money Mortgages.—It is customary to permit
without restriction the assumption of purchase-money mortgages.
These are liens attaching only to new property subsequently
acquired, and their assumption is not regarded as affecting the
position of the other bondholders. The latter supposition is
not necessarily valid, of course, since it is possible thereby to
increase the ratio of total debt of the enterprise to the total share¬
holder's equity in a manner which might jeopardize the position
of the existing bondholders.

Subordination cf Bond Issues to Bank Debt in Reorganization.
In the case of bonds or notes issued under a reorganization plan
it is sometimes provided that their claim shall be junior to that
of present or future bank loans. This is done to facilitate bank
borrowings which otherwise could be effected only by the
pledging of receivables or inventories as security. An example
of this arrangement is afforded by Aeolian Company Five-year
Secured 6% Notes, due in 1937, which were issued under a
capital readjustment plan in partial exchange for the Guaranteed
7% Preferred Stock of the company. The notes were sub¬
ordinated to $400,000 of bank loans, which were later paid.

Safeguards against Creation of Additional Amounts of the
Same Issue.—Nearly all bonds or preferred issues enjoy adequate
safeguards in respect to the creation of additional amounts of
the issue. The customary provisions require a substantial
margin of earnings above the requirements of the issue as thus
enlarged. For example, additional New York Edison Company
First Lien and Refunding Mortgage Bonds may not be issued,
except for refunding purposes, unless consolidated net earnings

1 In exceptional cases, debenture obligations are entitled to a prior lien
on the property in the event that a subsequent mortgage is placed thereon.
Example: National Radiator Corporation Debenture 6^3, due 1947, and
the successor corporation’s income debenture 5s, due 1946. In a second
reorganization, effected in 1939, these debentures were replaced by stock.
Here is an excellent example of the relative unimportance of protective
provisions, as compared with profitable operations.

FIXED-VALUE INVESTMENTS

251

for a recent 12-month period have been at least times the
annual interest charges on the aggregate bonded indebtedness of
the company, including those to be issued. In the case of
Wheeling Steel Corporation First Mortgage bonds the required
ratio is 2 times. 1

Provisions of this kind with reference to earnings-coverage
are practically nonexistent in the railroad field, however. Rail¬
road bonds of the blanket-mortgage type more commonly restrict
the issuance of additional bonds through a provision that the
total funded indebtedness shall not exceed a certain ratio to the
capital stock outstanding, and by a limitation upon the emission
of new bonds to a certain percentage of the cost or fair value of
newly acquired property. (See, for example, the Baltimore and
Ohio Railroad Company Refunding and General Mortgage
Bonds and the Northern Pacific Railway Company Refunding
and Improvement Bonds.) In the older bond issues it was
customary to close the mortgage at a relatively small fixed
amount, thus requiring that additional funds be raised by the
sale of junior securities. This provision gave rise to the favorably
situated “underlying bonds” to which reference was made in
Chap. VI.

In the typical case additional issues of mortgage bonds may
be made only against pledge of new property worth considerably
more than the increase in debt. (See, for examples: Youngstown
Sheet and Tube Company First Mortgage, under which further
bonds may be issued to finance 75% of the cost of additions or
improvements to the mortgaged properties; New York Edison
Company, Inc., First Lien and Refunding Mortgage, under which
bonds may be issued in further amounts to finance additions and
betterments up to 75% of the actual and reasonable expenditure
therefor; Pere Marquette Railway Company First-mortgage
bonds, which may be issued up to 80% of the cost or fair value,
whichever is the lower, of newly constructed or acquired
property.)

These safeguards are logically conceived and almost always
carefully observed. Their practical importance is less than
might appear, however, because in the ordinary instance the

1 For similar provisions in the case of preferred stocks see Consolidated
Edison Company of New York $5 Preferred, General Foods Corporation
$4.50 Preferred and Gotham Silk Hosiery Company 7% Preferred.

252

SECURITY ANALYSIS

showing stipulated would be needed anyway in order to attract
buyers for the additional issue.

Working-capital Requirements. —The provisions for main¬
taining working capital at a certain percentage of bonded debt,
and for a certain ratio of current assets to current liabilities, are
by no means standardized. They appear only in industrial bond
indentures. 1

The required percentages vary, and the penalties for non-
observance vary also. In most cases the result is merely the
prohibition of dividends until the proper level or ratio of working
capital is restored. In a few cases the principal of the bond
issue may be declared due.

Examples: 1. Sole penalty , prohibition of dividends . B. F.
Goodrich First 43^s, due 1956, and Wilson and Company First
4s, due 1955, require current assets to equal total indebtedness,
i.e., net quick assets to equal funded debt. In the case of West
Virginia Pulp and Paper First 4j^s, due 1952, subsidiary pre¬
ferred stocks are included with funded debt.

The provisions of Fairbanks, Morse and Company Debenture
4s, due 1956, require that current assets equal (a) 110% of total
liabilities and (5) 200% of current liabilities. In the case of
Wheeling Steel First 4j^s, due 1966, and Republic Steel General
43^s, due 1956, current assets must equal 300% of current
liabilities, and net current assets must equal 50% of the funded
debt.

2. Failure to meet requirement is an event of default . Skelly Oil
Debenture 4s, due 1951, and Serial Notes, due 1937-1941.
Here the company agrees to maintain current assets equal to at
least 200% of current liabilities.

In the case of Continental Steel 4J^s, due 1946, the required
ratio is 115%.

Among former examples may be cited American Machine and
Foundry 6s, due 1939, which had a twofold provision: the first
prohibiting dividends unless net current assets equal 150% of
the outstanding bond issue, and the second requiring uncon¬
ditionally that the net current assets be maintained at 100% of
the face value of outstanding bonds. In the case of United
States Radiator Corporation 5s, due 1938, the company agreed

1 Ashland Home Telephone First 4^8, due 1961, are a public utility issue
with a peculiar, and rather weak, provision relating to net current assets.

FIXED-VALUE INVESTMENTS

253

at all times to maintain net working capital equal to 150% of the
outstanding funded debt.

It would appear to be sound theory to require regularly some
protective provisions on the score of working capital in the case
of industrial bonds. We have already suggested that an adequate
ratio of net current assets to funded debt be considered as one of
the specific criteria in the selection of industrial bonds. This
criterion should ordinarily be set up in the indenture itself, so
that the bondholder will be entitled to the maintenance of a
satisfactory ratio throughout the life of the issue and to an
adequate remedy if the figure declines below the proper point.

The prohibition of dividend payments under such conditions
is sound and practicable. But the more stringent penalty,
which terms a deficiency of working capital “an event of default,”
is not likely to prove effective or beneficial to the bondholder.
The objection that receivership harms rather than helps the
creditors applies with particular force in this connection. Refer¬
ring to the United States Radiator 5s, mentioned above, we may
point out that the balance sheet of January 31, 1933, showed a
default in the 150% working-capital requirement (The net
current assets were $2,735,000, or only 109% of the $2,518,000
bond issue.) Nevertheless, the trustee took no steps to declare
the principal due, nor was it asked to do so by the required number
of bondholders. In all probability a receivership invoked for
this reason would have been considered as highly injurious
to the bondholder interests. But this attitude would mean
that the provision in question should never have been included
in the indenture. 1

Voting Control as a Remedy.—We have previously advanced
and discussed the suggestion that the bondholder right to the
appointment of trustees in the event of any default might well
be replaced by a right to receive voting control over the enterprise.

1 Similar situations existed in 1933 with respect to G. R. Kinney (shoe)
Company 7Ks» due 1936, and Budd Manufacturing Company First 6s, due
1935. Early in 1934, the United States Radiator Corporation asked the
debenture holders to modify the provisions respecting both working-capital
maintenance and sinking-fund payments. No substantial quid pro quo was
offered for these concessions. Characteristically, the reason given by the
company itself for this move was not that the bondholders were entitled to
some remedial action but that the “technical default under the indenture’ 1
interfered with projected bank borrowings by the company.

254

SECURITY ANALYSIS

Whatever the reader's view as to the soundness of this suggestion
as applied to default in payment of interest or principal, we
imagine that he will agree with us that it has merit in the case
of “secondary ” defaults, e.g ., failure to maintain working capital
as agreed or to make sinking-fund payments; for the present
alternatives—either to precipitate insolvency or to do nothing at
all—are alike completely unsatisfactory.

Protective Provisions for Investment-trust Issues. —Invest¬
ment-trust bonds belong in a special category, we believe, because
by their nature they lend themselves to the application of strin¬
gent remedial provisions. Such bonds are essentially similar to
the collateral loans made by banks on marketable securities. As
a protection for these bank loans, it is required that the market
value of the collateral be maintained at a certain percentage in
excess of the amount owed. In the same way the lenders of
money to an investment trust should be entitled to demand that
the value of the portfolio continuously exceed the amount of the
loans by an adequate percentage, e.g., 25%. If the market value
should decline below this figure, the investment trust should be
required to take the same action as any other borrower against
marketable securities. It should either put up more money
( i.e ., raise more capital from the stockholders) or sell out securities
and retire debt with the proceeds, in an amount sufficient to
restore the proper margin.

The disadvantages that inhere in bond investment generally
justify the bond buyer in insisting upon every possible safeguard.
In the case of investment-trust bpnds, a very effective measure
of protection may be assured by means of the covenant to main¬
tain the market value of the portfolio above the bonded debt.
Hence investors in investment-trust issues should demand this
type of protective provision, and—what is equally important—
they should require its strict enforcement. Although this stand
will inflict hardship upon the stockholders when market prices
fall, this is part of the original bargain, in which the stockholders
agreed to take most of the risk in exchange for the surplus
profits. 1

1 If the market value of the assets falls below 100% of the funded debt, a
condition of insolvency would seem to be created which entitles the bond¬
holders to insist upon immediate remedial action. For otherwise the stock¬
holders would be permitted to speculate on the future with what is entirely

FIXED-VALUE INVESTMENTS

255

A survey of bond indentures of investment trusts discloses a
signal lack of uniformity in the matter of these protective pro¬
visions. Most of them do require a certain margin of asset
value over debt as a condition.to the sale of additional bonds.
The required ratio of net assets to funded debt varies from 120%
(e.g. } General American Investors) to 250% (e. 0 ., Niagara Shares
Corporation). The more usual figures are 125 or 150%. A
similar restriction is placed upon the payment of cash dividends.
The ratio required for this purpose varies from 125% (e.g.,
Domestic and Foreign Investors) to 175% (which must be shown
to permit cash dividends on Central States Electric Corporation
common). The modal figure is probably 140 or 150%.

But the majority of issues do not require at all times and
unconditionally the maintenance of a minimum excess of asset
value above bonded indebtedness. Examples of such a covenant
ipay indeed be given, e.g. } General Public Service Corporation
Convertible Debenture 5s, due 1953; American European Securi¬
ties Company Collateral 5s, due 1958; and Affiliated Fund, Inc.,
Secured Convertible Debenture 4J^s and 4s, due 1949, all of
which require maintenance of a 125% ratio of asset value at
market to funded debt. In the case of Affiliated Fund, the
remedy provided is the immediate sale by the trustee of pledged
collateral and the retirement of bonds until the required ratio is
restored. In the other cases more elaborate machinery is invoked
to declare the entire issue due and payable. We would suggest
that provisions of this type—preferably those most simple of
application—be a standard requirement for investment-trust
bond issues . 1

the bondholders 1 capital. But even this apparently simple point is not
without its difficulties. In 1938, holders of Reynolds Investing Company 5s
endeavored to have a trustee appointed on grounds of insolvency, but stock¬
holders claimed that the market price of certain large security holdings was
less than their real value. After considerable delay, trustees were appointed,
pursuant to an agreement among the various interests. Note that Guardian
Investors Corporation 5s, due 1948, have been "under water" nearly all
the time since 1932 and sold as low as 24, without any remedial steps* being
taken.

1 Another type of remedy appeared in the indenture securing the Reynolds
Investing Company 5s, which provided that if at any time the net value of
the assets should fall below 110% of the bond issue, the latter should be
due and payable on the next interest date. The same difficulty arose in

256

SECURITY ANALYSIS

SINKING FUNDS

In its modern form a sinking fund provides for the periodic
retirement of a certain portion of a senior issue through pay¬
ments made by the corporation. The sinking fund acquires
the security by call, by means of sealed tenders, or by open-
market purchases made by the trustee or the corporation. In
the latter case the corporation turns in the bonds to the sinking
fund in lieu of cash. The sinking fund usually operates once
or twice a year, but provisions for quarterly and even monthly
payments are by no means unusual. In the case of many bond
issues, the bonds acquired by the sinking fund are not actually
retired but are “kept alive,” i.e. } they draw interest, and these
interest sums are also used for sinking-fund purchases, thus
increasing the latter at a compounded rate.

Example: An important instance of this arrangement was sup¬
plied by the two issues of United States Steel Sinking Fund 5s,
originally totalling $504,000,000. Bonds of the junior issue,
listed on the New York Stock Exchange, were familiarly known
in the bond market as “Steel Sinkers.” By adding the interest
on bonds in the fund, the annual payments grew from $3,040,000
in 1902 to $11,616,000 in 1928. (The following year the entire
outstanding amounts of these issues were retired or provided for.)

Benefits. —The benefits of a sinking fund are of a twofold
nature. The continuous reduction in the size of the issue makes
for increasing safety and the easier repayment of the balance at
maturity. Also important is the support given to the market
for the issue through the repeated appearance of a substantial
buying demand. Nearly all industrial bond issues have sinking
funds; the public-utility group shows about as many with as
without; in the railroad list sinking funds are exceptional. But
in recent years increasing emphasis has been laid upon the

applying this provision as in the case of the solvency question discussed
above.

Note also the case of Alleghany Corporation Collateral Trust 5s, due
1949. The offering circular indicated that a coverage of 150% would be
compulsory. Yet the indenture provided that failure to maintain this
margin would not constitute an event of default but would result only in the
prohibition of dividends and in the impounding by the trustee of the income
from the pledged collateral.

FIXED-VALUE INVESTMENTS

257

desirability of a sinking fund, and few long-term senior issues
of any type are now offered without such a provision. 1

Indispensable in Some Cases. —Under some circumstances a
sinking fund is absolutely necessary for the protection of a bond.
This is true in general when the chief backing of the issue con¬
sists of a wasting asset. Bonds on mining properties invariably
have a sinking fund, usually of substantial proportions and based
upon the tonnage mined. A sinking fund of smaller relative
size is regularly provided for real estate mortgage bonds. In all
these cases the theory is that the annual depletion or depreciation
allowances should be applied to the reduction of the funded
debt.

Examples: A special example of importance was the large Inter¬
borough Rapid Transit Company First and Refunding 5% issue,
due 1966, which was secured mainly by a lease on properties that
belong to the City of New York. Obviously it was essential to
provide through a sinking fund for the retirement of the entire
issue by the time the lease expired in 1967, since the corporation
would then be deprived of most of its assets and earning power.
Similarly with Tobacco Products 6J^s, due in 2022, which
depended for their value entirely upon the annual payments of
$2,500,000 made by American Tobacco Company under a lease
expiring in 2022.

The absence of a sinking fund under conditions of this kind
invariably leads to trouble.

Examples: Federal Mining and Smelting Company supplied
the unusual spectacle of a mining enterprise with a large preferred-
stock issue ($12,000,000); and furthermore the preferred stock
had no sinking fund. Declaration of a $10 dividend on the
common in 1926 led to court action to protect the preferred stock
against the threatened breakdown of its position through deple¬
tion of the mines coupled with the distribution of cash earnings
to the junior shares. As a result of the litigation the company
refrained from further common dividends until 1937 and devoted
its surplus profits to reducing the preferred issue, which was
completely retired in 1939.

1 During 1933 the Interstate Commerce Commission strongly recom¬
mended that railways adopt sinking funds to amortize their existing debt.
The Chicago and North Western Railway thereupon announced a plan of
this kind, the details of which were not particularly impressive.

258

SECURITY ANALYSIS

Iron Steamboat Company General Mortgage 4s, due 1932,
had no sinking fund, although the boats on which they were a
lien were obviously subject to a constant loss in value. These
bonds to the amount of $500,000 were issued in 1902 and were a
second lien on the entire property of the company (consisting
mainly of seven small steamboats operating between New York
City and Coney Island), junior to $100,000 of first-mortgage
bonds. During the years 1909 to 1925, inclusive, the company
paid dividends on the common stock aggregating in excess of
$700,000 and by 1922 had retired all of the first-mortgage bonds
through the operation of the sinking fund for that issue. At this
point the 4s, due 1932, became a first lien upon the entire prop¬
erty. In 1932, when the company went into bankruptcy, the
entire issue was still outstanding. The mortgaged property
was sold at auction in February 1933 for $15,050, a figure result¬
ing in payment of less than 1 cent on the dollar to the bondholders.
An adequate sinking fund might have retired the entire issue out
of the earnings which were distributed to the stockholders.

When the enterprise may be regarded as permanent, the
absence of a sinking fund does not necessarily condemn the issue.
This is true not only of most high-grade railroad bonds and of
many high-grade utility bonds but also of most of the select
group of old-line industrial preferred stocks that merit an invest¬
ment rating, e.g.j National Biscuit Preferred, which has no sinking
fund. From the broader standpoint, therefore, sinking funds
may be characterized as invariably desirable and sometimes but
not always indispensable.

Serial Maturities as an Alternative.—The general object
sought by a sinking fund may be obtained by the use of serial
maturities. The retirement of a portion of the issue each year
by reason of maturity corresponds to the reduction by means of
sinking-fund purchases. Serial maturities are relatively infre¬
quent, their chief objection resting probably in the numerous
separate market quotations that they entail. In the equip¬
ment-trust field, however, they are the general rule. This
exception may be explained by the fact that insurance companies
and other financial institutions are the chief buyers of equipment
obligations, and for their special needs the variety of maturity
dates proves a convenience. Serial maturities are also frequently
employed in state and municipal financing.

FIXED-VALUE INVESTMENTS

259

Problems of Enforcement. —The enforcement of sinking-fund
provisions of a bond issue presents the same problem as in the
case of covenants for the maintenance of working capital.
Failure to make a sinking-fund payment is regularly characterized
in the indenture as an event of default, which will permit the
trustee to declare the principal due and thus bring about receiver¬
ship. The objections to this “remedy” are obvious, and we can
recall no instance in which the omission of sinking-fund payments,
unaccompanied by default of interest, was actually followed by
enforcement of the indenture provisions. When the company
continues to pay interest but claims to be unable to meet the
sinking fund, it is not unusual for the trustee and the bond¬
holders to withhold action and merely to permit arrears to
accumulate. More customary is the making of a formal request
to the bondholders by the corporation for the postponement of
the sinking-fund payments. Such a request is almost invariably
acceded to by the great majority of bondholders, since the alterna¬
tive is always pictured as insolvency. This was true even in the
case of Interborough Rapid Transit 5s, for which—as we have
pointed out—the sinking fund was an essential element of
protection. 1

The suggestion made in respect to the working-capital cove¬
nants, viz., that voting control be transferred to the bondholders
in the event of default, is equally applicable to the sinking-fund
provision. In our view that would be distinctly preferable to
the present arrangement under which the bondholder must
either do nothing to protect himself or else take the drastic and
calamitous step of compelling bankruptcy.

The emphasis we have laid upon the proper kind of protective
provisions for industrial bonds should not lead the reader to
believe that the presence of such provisions carries an assurance
of safety. This is far from the case. The success of a bond
investment depends primarily upon the success of the enterprise

1 The plan of voluntary readjustment proposed in 1922 postponed sinking-
fund payments on these bonds for a five-year period. About 75% of the
issue accepted this modification.

Sinking-fund payments have been suspended without penalty in the case
of numerous real estate issues, under the provisions of various state mortgage
moratorium laws. Example: Harriman Building First 6s, due 1951. No
sinking-fund payments were made between 1934 and 1939 by virtue of the
New York Moratorium Law.

260

SECURITY ANALYSIS

and only to a very secondary degree upon the terms of the
indenture. Hence the seeming paradox that the senior securities
that have fared best in the depression have on the whole quite
unsatisfactory indenture or charter provisions. The explanation
is that the best issues as a class have been the oldest issues, and
these date from times when less attention was paid than now to
protective covenants.

In Appendix Note 34, we present two examples of the opposite
kind (Willys-Overland Company First 6j^s, due 1933, and
Berkey and Gay Furniture Company First 6s, due 1941) wherein
a combination of a strong statistical showing with all the standard
protective provisions failed to safeguard the holders against a
huge subsequent loss. But while the protective covenants we
have been discussing do not guarantee the safety of the issue,
they nevertheless add to the safety and are therefore worth
insisting upon.

CHAPTER XX

PREFERRED-STOCK PROTECTIVE PROVISIONS.
MAINTENANCE OF JUNIOR CAPITAL

Preferred stocks are almost always accorded certain safeguards
against the placing of new issues ahead of them. The standard
provision prohibits either a prior stock or a mortgage-bond issue
except upon approval by vote of two-thirds or three-fourths of
the preferred stock. The prohibition is not made absolute
because conditions are always within contemplation under which
the preferred stockholders may find it to their advantage to
authorize the creation of a senior issue. This may be done
because new financing through a bond issue is necessary to avoid
receivership. An example is afforded by Eitingon-Schild Com¬
pany in 1932. According to the provisions of the 6*^% First
Preferred stock the company could not create a mortgage, lien,
or charge on any of its property, except purchase-money obliga¬
tions, extensions of existing mortgages, and pledge of liquid
assets to secure loans made in the ordinary course of business.
Because of the precarious financial condition of the company in
1932 the preferred stockholders authorized certain financial
rearrangements, including the creation of a $5,500,000-issue of
5% debentures containing certain provisions the effect of which
was to create a special charge against fixed properties.

Protection against Creation of Unsecured Debt Desirable.—
It is a common practice to give preferred stockholders no control
over the creation of unsecured debt. This point is exemplified
by the American Metal Company, which in 1930 issued $20,000,-
000 of debenture notes without vote of the preferred stockholders
but in 1933 was compelled to ask for their approval of the possible
pledging of collateral to refund the notes at maturity. This
distinction appears to us to be unsound, since unsecured debt is
just as much a threat to a preferred stock as is a mortgage
obligation. It does seem illogical to provide, as is usually done,
that preferred stockholders may forbid the issuance of new

261

262

SECURITY ANALYSIS

preferred shares ranking ahead of or equivalent to theirs and
also of any secured indebtedness, but that they have nothing to
say about the creation of a debenture bond issue, however large.

Presumably this exclusion arose from the desire to permit
bank borrowing for ordinary business purposes, but this point
may be taken care of by a specific stipulation to that effect—just
as the standard provision now used permits the pledge of assets
to secure “loans made in the ordinary course of business” without
requiring preferred stockholder consent. 1

The preferred stockholders' vote is rather frequently availed
of to permit the issuance of an equal-ranking or even a prior
security which is to be exchanged for the preferred stock itself
under a recapitalization plan, the latter usually being designed
to dispose of accumulated dividends. By giving the new issue
equality with or priority over the old, stockholders who might
otherwise be inclined to reject the composition arc almost com¬
pelled to accept it.

Examples: In 1930 Austin Nichols and Company had 7%
preferred stock outstanding on which dividends of $21 per share
had accumulated. The company offered to exchange each share
for one share of $5 Cumulative Prior A stock plus 1.2 shares of
common. By vote of the preferred stockholders accepting the
plan, the new Prior A stock was made senior to the old preferred.
As a result, about 99% of the latter was turned in for exchange.
International Paper and Fisk Rubber made similar adjustments
of back dividends on the preferred in 1917 and 1925, respectively.
In these cases, additional preferred stock was issued ranking
equally with the old shares. 2

1 It should be noted, however, that there b a growing tendency in recent
years to protect preferred stockholders against the creation of debenture
bonds by requiring their approval of the issuance of any “ bonds, notes,
debentures or other evidence of indebtedness maturing later than one year
from the date of their issue.” See for example: the Kendall Company $6
Participating Preferred, A. M. Byers Company 7% Preferred. Among the
older issues Loose-Wiles Biscuit Company 7 % First Preferred had this type
of protection.

* More recent laws of some states have permitted companies to compel all
preferred stockholders to accept a recapitalization plan upon a two-thirds
affirmative vote. Example: The recapitalization of International Paper and
Power in 1937 (under the laws of Massachusetts) replaced the original 6%
preferred and the successor 7 % preferred (together with their accumulated
dividends) by a new convertible 5% preferred, plus a bonus of common

FIXED-VALUE INVESTMENTS

263

Preferred-stock Sinking Funds.—Very few public-utility or
railroad preferred-stock issues have a sinking-fund provision.
But in the case of industrial preferred-stock offerings sinking
funds have become the general rule. The advantages that
bonds derive from a sinking fund are equally applicable to pre¬
ferred stocks. Furthermore, in view of the weak contractual
position of preferred stocks, which we have frequently empha¬
sized, there is the more reason for the buyer to insist on special
protective arrangements of this kind. But although a sinking
fund is thus a highly desirable feature of a preferred issue, its
presence is no assurance, nor is its absence a negation of adequate
safety. The list of 21 preferred stocks (given in Chap. XIV) that
maintained an investment status throughout 1932-1933 contains
only one issue with a sinking-fund provision. As previously
explained, this paradox is due to the fact that nearly all the strong
industrial preferreds are old established issues, and the sinking
fund is a relatively recent development.

The amount of the sinking fund is usually fixed at a certain
percentage of the maximum amount of preferred stock at any
time outstanding, 3% being perhaps the most frequent figure.
Less often the amount is based on a percentage of profits. There
are a number of variations and technicalities of a descriptive
nature, which we shall not detail. In most cases the payment
of the sinking fund is obligatory, provided: (1) preferred dividends
have been paid in full or “ provided for,” and (2) there remain
surplus profits equal to the sinking-fund requirement.

A small number of preferred stocks are protected by an agree¬
ment to maintain net current assets, usually at 100% of the
preferred issue or 100% of the preferred stock plus bond issues.
In some cases the penalty for nonobservance is merely a prohibi¬
tion of common dividends (c.g., Sidney Blumenthal and Com¬
pany), whereas in other cases voting control passes to the

stock. The effect of various court decisions has been to hold, however,
that, in the case of corporations formed prior to the enactment of these
statutes, the claim for accumulated dividends is a vested right which cannot
be taken away by stockholders* vote.

See Keller vs. Wilson & Co., Inc., 190 Atl. 115 (Del. 1936), and S.E.C.
Report on the Study and Investigation of the Work, Activities, Personnel and
Functions of Protective and Reorganization Committees, Pt. VIII, “ Manage¬
ment Plans without Aid of Committees,** pp. 187 et seq. t United State*
Government Printing Office, 1938.

264

SECURITY ANALYSIS

preferred stock (e.g., A. G. Spalding and Brothers 7% First
Preferred, where working capital was required to equal 125% of
the preferred issue). 1

Voting Power in the Event of Nonpayment of Dividends. —The

second general type of protective provision for preferred stocks
relates to voting power accruing in the event of nonpayment of
dividends. As far as we know, these stipulations apply only to
cumulative issues. The arrangement varies with respect to
when the voting power becomes effective and to the degree of
control bestowed. In a few cases (e.^., Kaufmann Department
Stores 7% Preferred and Royal Baking Powder Company 6%
Preferred) the voting right accrues after one dividend is omitted.
At the other extreme, the right becomes effective only after eight
quarterly payments are in default ( e.g., Brunswick-Balkc-
Collender Company). The customary period allowed is one
year. The right conferred upon the preferred stock may be:
(1) to vote exclusively for the directors, (2) to elect separately a
majority of the board, (3) to elect separately a minority of the
board, or (4) to vote share for share with the common stock.

Example of (1): McKesson and Robbins, Inc., Preferred
Stock received the sole right to elect the directors upon omission
of the fourth quarterly dividend in December 1932.

Example of (2): In 1933 Hahn Department Stores Preferred
obtained the right to elect a majority of the board, because of
the omission of four quarterly dividends.

Example of (3): Universal Pictures First Preferred has the
right to elect two directors in the event of default of six quarterly
dividends. Brooklyn and Queens Transit Corporation Preferred
may elect one-third of the board if all arrears are not paid up
within a year after any quarterly dividend is omitted.

Example of (4): City Ice and Fuel Preferred votes share for
share with the common in the event of nonpayment of four
quarterly dividends. 2

1 In 1939 the 7% First Preferred was replaced by income bonds, new
preferred and common.

* An unusual variation of this idea was found in the case of Du Pont “Non¬
voting Debenture Stock” (a preferred issue), retired in 1939. The holders
were given the right to vote equally with the common stock in the event that
the earnings for any calendar year fell below 9% on the debenture stock
issue. They received exclusive voting power if dividends were in default
for six months.

FIXED-VALUE INVESTMENTS

265

The value of the last arrangement would seem to depend a
good deal on whether the preferred stock is larger or smaller
than the common issue. If larger, the share-for-share voting
right could give the issue effective control; but in most cases
the preferred issue is smaller, and hence this voting right is likely
to prove ineffective.

Composite Rights .—West Penn Power 4J^% Preferred and
Wisconsin Gas and Electric 4*^% Preferred, both issued in 1939,
have the following voting rights: (1) a vote share for share with
the common, unless: (2) a year’s dividend is in default, in which
case the preferred stockholders have the right to elect two addi¬
tional directors; (3) if three years’ dividends are in default, they
have the right to elect a majority of the board. North American
Company 6% Preferred Stock can always elect one-quarter of the
board. If three years’ dividends are in arrears, it can elect a
majority of the directors.

Noncumulative Issues Need Greater Protection. —The prac¬
tices outlined above merit certain other criticisms of a more
general nature. In the first place, although it is taken for granted
that these special voting provisions should apply to cumulative
preferred stocks only, the exclusion of noncumulative issues
seem to us to be most illogical. Their holders have certainly a
greater reason to demand representation in the event of non¬
payment, because they have no right to recover the lost dividends
in the future. In our view it should be established as a financial
principle that any preferred stock that is not paying its full
dividend currently should have some separate representation on
the board of directors.

On the other hand we do not consider it proper to deprive
the common stock of all representation when preferred dividends
are unpaid. Complete domination of the board by the preferred
stockholders may lead to some practices distinctly unfair to
the common stock, e.g. y perpetuation of preferred-stock control
by unnecessarily refraining from paying up back dividends in
full. An alert minority on the board of directors, even though
powerless in the actual voting, may be able to accomplish a great
deal in preventing unfair or unsound practices.

A General Canon Regarding Voting Power.—From the fore¬
going discussion, a general canon with respect to voting power
may readily be formulated. The standard arrangement should

266

SECURITY ANALYSIS

give every preferred and every common issue the separate right
to elect some directors under all circumstances . l It would be
logical for the common stock to elect the majority of the board
as long as preferred dividends were regularly paid and equally
logical that whenever the full dividend was not paid, on either
a cumulative or noncumulative preferred issue, the right to
choose the majority of the board should pass to the preferred
stockholders. 2

Adequate protection for preferred issues should require that
voting control pass to the holders in the event not only of default
in dividends but also of nonpayment of the sinking fund or the
failure to maintain working capital as stipulated. A few charters,
e.g.j those of Bayuk Cigars and A. G. Spalding, afford this three¬
fold remedial right to the preferred stockholders. In our view,
this practice should be standard instead of exceptional.

Value of Voting Control by Preferred Stock May Be Ques¬
tioned. —Viewing the matter realistically, it must be admitted
that the vesting of voting control in holders of a preferred issue
docs not necessarily prove of benefit to them. In some cases, per¬
haps, no effective use can be made of this privilege; in other cases
the holders are too inert—or too poorly advised—to protect their
interests even though they have power to do so. These practical
limitations may be illustrated by a case in point, viz., the Maytag
Company.

In 1928 this enterprise (manufacturing washing machines)
was recapitalized and issued the following securities:

100,000 shares of $6 Cumulative First Preferred.

320,000 shares of $3 Cumulative Preference (Second Preferred).

1,600,000 shares of common.

1 So far as we have been able to determine, such issues are comparatively
rare. See, however, North American Company Preferred and the new
preferred stock of Ogden Corporation (successor to Utilities Power and Light
Corporation). It seems probable that more such issues will be forthcoming
under S.E.C. auspices. On the general subject of preferred stockholders'
voting rights see W. II. S. Stevens, “ Voting Rights of Capital Stock and
Shareholders,” XI The Journal of Business of the University of Chicago ,
311-348, October, 1938.

2 Section 216-12(a) of Chap. X of the Bankruptcy Act of 1938 apparently
requires that preferred shares issued thereunder be given the right to elect
some directors in the event of any default in dividends.

FIXED-VALUE INVESTMENTS

267

Approximately 80% of all these shares were received by the
Maytag family. Through investment bankers they sold to the
public their holdings of first and second preferred. This netted
them individually ( i.e ., not the company) the sum of about
$20,000,000. They retained control of the business through their
ownership of common stock. The charter provided that neither
preferred issue should have voting rights unless four quarterly
dividends were defaulted on either. In that case both issues,
voting together as a single class, would have the right to elect
a majority of the directors. In 1932 dividends were omitted on
both classes of preferred. Voting control consequently passed
to the holders of these issues early in 1933.

Peculiarly enough, the only change made during the 1932-1933
period in the board of directors was the resignation of the single
member who—as partner of one of the issuing houses—had
presumably represented the preferred stockholders. All of the
five directors remaining w r cre operating officials and closely
identified with the common-stock ownership. In the meantime
the price of the two preferred issues declined to 15 and 3)^,
respectively, as compared with original offering prices of 101
and 50.

Reviewing the situation, we see private owners of a business
selling a preferred claim against its profits for a very large sum,
which they retained individually. To protect the public’s stake
in the enterprise, the preferred issues were given voting control
in the event of continued nonpayment of dividends. This
event occurred and with it a catastrophic decline in the value
of the shares. But the new voting control was not exercised,
and the board of directors remained dominated, even more com¬
pletely than before, by those owning the common stock.

Wall Street’s attitude toward this incident would be that,
since the management of the company was honest and capable, a
change in the directorate would be unnecessary and even unwise.
In our opinion this reasoning misses the basic point. No doubt
the operating management should remain unchanged; possibly—
though by no means certainly—directors representing the pre¬
ferred stock would follow the same financial policies in matters
affecting the senior issues as would be followed by a board
identified with the common stock. But the crux of the matter is
that these decisions should actually be made by a board of

268

SECURITY ANALYSIS

directors of which the majority has been selected by the preferred
stockholders in accordance with their rights. Regardless of
whether or not a change in the board would result in any change
in policy, the directors should be chosen as provided in the
articles of incorporation. For otherwise the voting provision is
entirely meaningless. It becomes merely a phrase to persuade
the preferred-stock buyer into believing he has safeguards that
are in fact nonexistent. 1

Recommended Procedure in Such Cases .—In the authors' view
the proper procedure in cases such as the Maytag situation is
perfectly clear. The preferred stockholders individually have
no satisfactory means of going about the nomination and election
of directors to represent them. This duty should devolve upon
the issuing houses, and they should discharge it conscientiously.
They should: (1) obtain a list of the preferred stockholders of
record, (2) advise them of their new voting rights, and (3) recom¬
mend to them a slate of directors and request their proxies to vote
for these nominees. The directors suggested should, of course,
be as well qualified as possible for their posts. They must be
free from any large interest in or close affiliation with the common
stock, and it would be desirable if they were themselves sub¬
stantial owners of preferred shares. (In the case of preferred
stock issued pursuant to reorganization, there may be no issuing
house to take the initiative, but this may be done by the same
agencies formerly active in behalf of the security holders in the
reorganization itself.)

It is quite possible, none the less, that the directors chosen
by the preferred stockholders will be incompetent or for other
reasons fail to represent their interests properly. But this is
not a valid argument against the possession and the exercise
of voting power by preferred stockholders. The same objection
applies to voting rights of common stockholders—and of citizens.
The remedy is not disenfranchisement but education. As we
have previously pointed out, a combination of adequate voting-
control provisions for preferred shares with their prompt and
effective use could largely overcome the disadvantages inherent
in the absence of an unqualified legal right to receive dividends.
But until both these conditions are fulfilled, we must continue to

1 It should be added that the dividends on Maytag $6 Preferred were
resumed in October 1933 and accumulations discharged in 1934.

FIXED-VALUE INVESTMENTS

269

stress the practical superiority for investors of the bond form over
the preferred-stock form.

Maintenance of Adequate Junior Capital. —We wish to call
attention finally to a protective requirement for both bondholders
and preferred stockholders which is technically of great impor¬
tance but which frequently is not taken care of in indentures
or charter provisions. The point referred to is the maintenance
of an adequate amount of junior capital. We have previously
emphasized the principle that such junior capital is an indis¬
pensable condition for any sound fixed-value investment. No
loan could prudently be made to a business at 3 or 4% interest
unless the business were worth a considerable amount over and
above the amount borrowed. This is elementary and well
understood. But it is not generally realized that the corporation
laws permit the withdrawal of substantially all the capital and
surplus after the loan has been made. This can be done by the
legal process of reducing the capital to a nominal sum and
distributing the amount of the reduction to the stockholders.
Such a maneuver the creditors are powerless to prevent unless
they have specifically guarded against it in their loan contract.

Danger in the Right to Reduce Stated Capital .—Let us attempt
to bring this point home by a hypothetical example. A company
is engaged in the business of lending money on installment
accounts. It has $2,100,000 of capital and surplus. Ostensibly
for the purpose of expanding its operations, it borrows $2,000,000
by sale of a 20-year 5% debenture bond issue. The earnings
and stock equity appear to provide sufficient protection for the
bonds. Business subsequently falls off, and the company has a
substantial amount of unused cash. The stockholders vote to
reduce the capital to $100,000 (in theory it might be reduced
to $1), and they receive back $2,000,000 in cash, as a return of
capital.

In effect the stockholders have recovered their capital with
the cash supplied by the bondholders, but they retain ownership
and control of the business together with the right to receive
all profits above 5%. The bondholders find themselves in the
absurd position of having provided all the capital and having
thereby assumed all the risk of loss, without any share in the
profits above ordinary interest. Such a development would be
most unfair, but apparently it can be carried out legally unless

270

SECURITY ANALYSIS

the indenture of the bond issue specifically prevented it by
stipulating that no distributions could be made to the stock¬
holders that would reduce the capital and surplus below a certain
figure.

The removal of the bondholders' “cushion” by its direct
withdrawal in cash—as in our hypothetical example—is a rare,
perhaps unexampled, occurrence. But a corresponding situation
does actually arise in practice through a combination of large
operating losses followed by a reduction in capital to wipe out
the consequent balance sheet deficit.

Examples: In Chap. XXXVIII we refer to an extraordinary
example of this kind, viz., the Interborough-Metropolitan case.
Here the stated capital was reduced by stockholder action to
eliminate a huge profit-and-loss deficit. Following this action,
earnings of a distinctly temporary character were disbursed in
dividends, instead of being conserved for the benefit of the bond¬
holders, who later suffered a tremendous loss. To effect the
capital reduction under the laws then existing, a “merger” with
a dummy corporation was resorted to. The same artifice has
been used several times since in connection with recapitalization
schemes, e.g., Central Leather Company in 1926 and Kelly-
Springfield Tire Company in 1932.

As the result of losses sustained during the depression of the
1930s numerous reductions of capitalization have been voted
by the stockholders. These actions have been taken without
consulting the bondholders. Most of such reductions have
been effected by changes from np-par shares to shares of a low
par value. Frequently this has been accompanied by write-offs
of intangible assets or mark-downs of fixed assets. Such write¬
downs of asset values on one side of the balance sheet and capital
on the other are of no special significance from the bondholders'
standpoint, except possibly in the fact that they may permit
unduly low depreciation charges and therefore unduly liberal
dividend payments. But in most of these cases a substantial
sum also has effectively been transferred from capital to surplus
and thus made available to absorb future operating losses and
to facilitate the resumption of dividends before past losses have
been made up.

For example, Remington Rand, Inc., changed its common stock
from no par to $1 par and thereby, together with cancellation

FIXED-VALUE INVESTMENTS

271

of shares held by the company itself, reduced the stated value
of the common from $17,133,000 to $1,291,000. It applied
$7,800,000 of this reduction to write down its intangible assets,
$2,300,000 additional to mark. down its plant account, and
$400,000 for miscellaneous write-downs and reserves. This left
about $5,350,000 actually transferred from capital to surplus.
In the same manner the par value of Lexington Utilities $6
Preferred Stock was reduced in 1935 from $100 to $25 per share,
with no change in dividend or other significant rights and for the
sole purpose of eliminating a capital deficit and permitting the
resumption of preferred dividends. This action destroyed about
three-quarters of the margin above funded debt which bond¬
holders were formerly entitled to have maintained before divi¬
dends could be paid. In subsequent years large sums were
disbursed in preferred dividends that otherwise would have been
held or invested to make good the bondholders’ “cushion.”

Similar reductions were made by New York Shipbuilding
Corporation; Servel, Inc.; Warner Brothers Pictures, Inc.; H. F.
Wilcox Oil and Gas Company; Thermoid Company. National
Acme Company reduced the par value of its capital stock twice,
from $50 to $10 in 1924 and from $10 to SI in 1933. The result
was a telescoping of its stated capital from $25,000,000 into
$500,000. In the case of Capital Administration Company
not only was the stated value of the common stock reduced, but
the $3 cumulative preferred stock was also given a fictitiously
low par value of S10.

Some Issues Protected against This Danger .—Fortunately for
the bondholders in some of these cases, the indentures contain
provisions prohibiting dividends or other distributions to the
stockholders unless there is an adequate margin of resources
above the indebtedness. In the case of Remington Rand
Debenture 5><£s, a threefold protection was supplied by the terms
of the trust indenture, viz.:

1. Cash dividends may be paid only out of earned surplus.

2. Cash dividends may be paid only if net tangible assets after deducting
the dividend in question shall equal at least 175% of the funded debt.

3. No stock may be retired, in excess of $3,500,000, except out of addi¬
tional paid-in capital or earned surplus.

The last provision is directed against the reduction of junior
capital by buying in preferred or common stock. It would be

272

SECURITY ANALYSIS

more satisfactory if it prohibited the acquisition (rather than the
retirement) of the company's own stock.

Protective provisions of these various kinds appear in many
but by no means all indentures. (They are absent, for example,
in the case of Lexington Utilities, New York Shipbuilding, and
Servel bonds, to name three of the companies that reduced their
stated capital by stockholders' vote.) From the foregoing
discussion, it should be clear that these covenants are essential
to the proper safeguarding of a bond issue. Conscientious
issuing houses and intelligent investors should insist on their
inclusion in all indentures. 1

Anomalous Position of Preferred Stocks in This Connection .—
The position of preferred stocks in this matter is a somewhat
peculiar one. Their holders have the same interest as have
bondholders in the maintenance of an adequate amount of junior
capital. But losses that result in a balance-sheet deficit will
legally prevent the payment not only of common dividends but
of preferred dividends as well. Hence the preferred stock¬
holders are likely to be very anxious for a reduction in the
stated value of the common stock, which will eliminate the
profit-and-loss deficit and permit the resumption of dividends
on their own shares. In such cases their interest in maintain¬
ing an adequate amount of junior capital is offset by their
greater desire to make dividends possible. (At the close of
1921, for example, losses taken by Montgomery Ward had created
a profit-and-loss deficit of $7,700,000, which had compelled
suspension of the preferred dividend. Accordingly holders of
this issue welcomed a reduction in the stated value of the com¬
mon stock from $28,300,000 to $11,400,000, which eliminated the
balance-sheet deficit and thus permitted the resumption of the
preferred dividends and discharge of the accumulations.)

1 Since this was written in 1934, it has come to be common practice to
include such safeguards in new bond indentures. Not only is there a prohi¬
bition against the reduction of stated capital, but there is a tendency also to
“freeze” the surplus as of the time of the bond issue, though often with some
leeway. Examples: The Youngstown Sheet and Tube First 4% and Deben¬
ture 3H% indentures limit cash distributions to shareholders to earnings
since Dec. 31, 1935, plus $5,000,000. In the case of Koppers Company
First and Collateral 4s, due 1951, distributions are limited to profits since
Jan. 1,1936, plus proceeds of sale of additional stock.

FIXED-VALUE INVESTMENTS

273

This situation has even been exploited by the common-stock-
holders to compel large concessions from the preferred holders
in connection with a profit-and-loss deficit. A notorious example
is the Central Leather reorganization plan, resulting in the forma¬
tion of a successor company, United States Leather. As the
price of their vote in favor of reducing the stated capital, the
common stockholders forced the preferred holders to waive their
back dividends and to reduce their cumulative right to future
dividends . 1

Preferred Stocks Need Both Specific Pjotective Provisions and
Voting Power for Their Protection .—These considerations confirm
our previously expressed criticisms of the preferred stock form
as an investment medium. It is not particularly difficult to
safeguard these issues against the withdrawal of junior capital;
this is frequently done and should always be done . 2 But to
deal satisfactorily from the preferred stockholders’ standpoint
with conditions resulting in a profit-and-loss deficit is a difficult
matter. It requires, above all, complete control of the corpora¬
tion’s policies by directors representing the preferred issue. This
serves to emphasize the importance of adequate voting power for
preferred stockholders in the event of nonpayment of dividends.

1 The International Paper and Power Company recapitalization of 1937,
referred to in a footnote on p. 262, involved a similar sacrifice by preferred
stockholders. It was approved by the S.E.C. with considerable qualms
and was cited by Commissioner Frank as a deplorable example in his
vigorous and lengthy dissent from the Commission's order of Jan. 30, 1939,
approving issuance of North American Company 6% Preferred Stock.

In this dissent he makes the interesting suggestion that preferred stock¬
holders can escape the dilemma we have discussed if the stated value of the
common is reduced to a low figure and a large special capital surplus thereby
created, against which losses could be charged which otherwise would result
in an impairment of capital. Coupled with this device is the suggestion
that, when a substantial reduction in this special capital surplus has taken
place, voting control should pass to the preferred stock.

1 For example, the charter of General American Investors Company, Inc.,
prohibits any dividend or other distribution on the common that will
reduce net assets below $150 per share of preferred stock. The charter of
Interstate Department Stores, Inc., requires the consent of holders of two-
thirds of the preferred stock to any distribution to the holders of common
stock of capital or surplus resulting from any statutory reduction of capital.

CHAPTER XXI

SUPERVISION OF INVESTMENT HOLDINGS

Traditional Concept of “Permanent Investment.” —A genera¬
tion ago “permanent investment” was one of the stock phrases
of finance. It was applied to the typical purchase by a conserva¬
tive investor and may be said to have embraced three con¬
stituent ideas: (1) intention to hold for an indefinite period; (2)
interest solely in annual income, without reference to fluctuations
in the value of principal; and (3) freedom from concern over
future developments affecting the company. A sound invest¬
ment was by definition one that could be bought, put away, and
forgotten except on coupon or dividend dates.

This traditional view of high-grade investments was first
seriously called into question by the unsatisfactory experiences
of the 1920-1922 depression. Large losses were taken on
securities that their owners had considered safe beyond the
need of examination. The ensuing seven years, although gener¬
ally prosperous, affected different groups of investment issues in
such divergent ways that the old sense of complete security—
with which the term “gilt-edged securities” was identified—
suffered an ever-increasing impairment. Hence even before the
market collapse of 1929, the danger ensuing from neglect of
investments previously made, and the need for periodic scrutiny
or supervision of all holdings, had been recognized as a new
canon in Wall Street. This principle directly opposed to the
former practice, is frequently summed up in the dictum, “There
are no permanent investments.”

Periodic Inspection of Holdings Necessary—but Trouble¬
some.—That the newer view is justified by the realities of
fixed-value investment can scarcely be questioned. But it must
be frankly recognized also that this same necessity for super¬
vision of all security holdings implies a rather serious indictment
of the whole concept of fixed-value investment. If risk of loss
can be minimized only by the exercise of constant supervisory

274

FIXED-VALUE INVESTMENTS

275

care, in addition to the painstaking process of initial choice, has
not such investment become more trouble than it is worth?
Let it be assumed that the typical investor, following the con¬
servative standards of selection herein recommended, will
average a yield of 3% % on a diversified list of corporate securities.
This 33^% return appears substantially higher than the 2J^%
obtainable from long-term United States government bonds and
also more attractive than the 2 or 23 ^% offered by savings banks.
Nevertheless, if we take into account not only the effort required
to make a proper selection but also the greater efforts entailed
by the subsequent repeated check-ups, and if we then add thereto
the still inescapable risk of depreciation or definite loss, it
must be confessed that a rather plausible argument can be con¬
structed against the advisability of fixed-value investments in
general. The old idea of permanent, trouble-free holdings was
grounded on the not illogical feeling that if a limited-return
investment could not be regarded as trouble-free it was not worth
making at all.

Superiority of United States Savings Bonds.—Objectively
considered, investment experience of the last decade undoubtedly
points away from the fixed-value security field and into the
direction of (1) United States government bonds or savings-bank
deposits; or (2) admittedly speculative operations, with endeavors
to reduce risk and increase profits by means of skillful effort;
or (3) a search for the exceptional combination of safety of
principal with a chance for substantial profit. For all people of
moderate means United States Savings Bonds undoubtedly offer
the most suitable medium for fixed-value investment. In fact
we are inclined to state categorically that, on the basis of 1940
interest yields, their superiority to other issues makes them the
only sensible purchase of this type. The reason is, of course, that
it is not possible to obtain a significantly higher return on invest¬
ment issues (save for a few obscure exceptions) without injecting
an element of principal risk which makes the commitment
unsound. In addition the holder’s redemption right before
maturity is a very valuable feature of the bonds. If only small
investors as a class would resolutely reject the various types of
“savings plans,” with their multifarious titles, now being offered
to him with an ostensible “sure income return” of 4 to 6%, and
thankfully take advantage of the 2.90% available on United

276

SECURITY ANALYSIS

States Savings Bonds, we are convinced that they would save in
the aggregate an enormous amount of money, trouble and
heartbreak.

But even if the ordinary investment problems of most investors
could be thus simply disposed of, many investors would remain
who must consider other types of fixed-value investment. These
include: (1) institutional investors of all kinds, e.g ., savings and
commercial banks, insurance companies, educational and philan¬
thropic agencies; (2) other large investors, e.g., corporations and
wealthy individuals; (3) those with moderate income derived
wholly from investments, since the maximum annual return
ultimately obtainable from United States Savings Bonds is
limited to $2,500 per annum. 1 It is true also that many smaller
investors will for one reason or another prefer to place part of
their funds in other types of fixed-value investment.

The second alternative, viz ., to speculate instead of investing,
is entirely too dangerous for the typical person who is building
up his capital out of savings or business profits. The disad¬
vantages of ignorance, of human greed, of mob psychology, of
trading costs, of weighting of the dice by insiders and manipu¬
lators, 2 will in the aggregate far overbalance the purely theoretical
superiority of speculation in that it offers profit possibilities
in return for the assumption of risk. We have, it is true, repeat¬
edly argued against the acceptance of an admitted risk to
principal without the presence of a compensating chance for
profit. In so doing, however, we have not advocated speculation
in place of investment but only intelligent speculation in prefer¬
ence to obviously unsound and ill-advised forms of investment.
We are convinced that the public generally will derive far better
results from fixed-value investments, if selected with exceeding
care, than from speculative operations, even though these may
be aided by considerable education in financial matters. It may
well be that the results of investment will prove disappointing;
but if so, the results of speculation would have been disastrous.

1 This is based on the maximum $7,500 permitted each year to one indi¬
vidual. After the tenth year of continued investment, an annual income of
$2,500 would accrue via the maturity of a $10,000 unit each year and its
replacement by a new $7,500 subscription.

* This factor has been greatly reduced by the operation of the Securities
Exchange Act of 1934.

FIXED-VALUE INVESTMENTS

277

The third alternative—to look for investment merit combined
with an opportunity for profit—presents, we believe, a suitable
field for the talents of the securities analyst. But it is a danger¬
ous objective to hold before the untrained investor. He can
readily be persuaded that safety exists where there is only promise
or, conversely, that an attractive statistical showing is alone
sufficient to warrant purchase.

Having thus considered the three alternative policies open to
those with capital funds, we see that fixed-value investment in the
traditional field of high-grade bonds and preferred stocks remains
a necessary and desirable activity for many individuals and
corporate bodies. It is quite clear also that periodic reexamina¬
tion of investment holdings is necessary to reduce the risk of loss.
What principles and practical methods can be followed in such
supervision?

Principles and Problems of Systematic Supervision; Switch¬
ing.—It is generally understood that the investor should examine
his holdings at intervals to see whether or not all of them may
still be regarded as entirely safe and that if the soundness of any
issue has become questionable, he should exchange it for a
better one. In making such a “switch” the investor must be
prepared to accept a moderate loss on the holding he sells out,
which loss he must charge against his aggregate investment
income.

In the early years of systematic investment supervision, this
policy worked out extremely well. Seasoned securities of the
high-grade type tended to cling rather tenaciously to their
established price levels and frequently failed to reflect a progres¬
sive deterioration of their intrinsic position until some time
after this impairment was discoverable by analysis. It was
possible, therefore, for the alert investor to sell out such holdings
to some heedless and unsuspecting victim, who was attracted
by the reputation of the issue and the slight discount at which
it was obtainable in comparison with other issues of its class.
The impersonal character of the securities market relieves this
procedure of any ethical stigma, and it is considered merely
as establishing a proper premium for shrewdness and a deserved
penalty for lack of care.

Increased Sensitivity of Security Prices .—In more recent years,
however, investment issues have lost what may have been called

278

SECURITY ANALYSIS

their " price inertia,” and their quotations have come to reflect
promptly any materially adverse development. This fact
creates a serious difficulty in the way of effective switching to
maintain investment quality. By the time that any real impair¬
ment of security is manifest, the issue may have fallen in price
not only to a speculative level but to a level even lower than
the decline in earnings would seem to justify. 1 (One reason
for this excessive price decline is that an unfavorable apparent
trend has come to influence prices even more severely than the
absolute earnings figures.) The owner’s natural reluctance to
accept a large loss is reinforced by the reasonable belief that he
would be selling the issue at an unduly low price, and he is
likely to find himself compelled almost unavoidably to assume
a speculative position with respect to that security.

Exceptional Margins of Safety as Insurance against Doubt.—
The only effective means of meeting this difficulty lies in following
counsels of perfection in making the original investment. The
degree of safety enjoyed by the issue, as shown by quantitative
measures, must be so far in excess of the minimum standards
that a large shrinkage can be suffered before its position need
be called into question. Such a policy should reduce to a very
small figure the proportion of holdings about which the investor
will subsequently find himself in doubt. It would also permit
him to make his exchanges when the showing of the issue is still
comparatively strong and while, therefore, there is a better
chance that the market price will have been maintained.

Example and Conclusion .—As a concrete example, let us assume
that the investor buys an issue such as the Liggett and Myers
Tobacco Company Debenture 5s, due 1951, which earned their
interest an average of nearly twenty times in 1934-1938, as
compared with the minimum requirement of three times. If a
decline in profits should reduce the coverage to four times, he
might prefer to switch into some other issue (if one can be found)
that is earning its interest eight to ten times. On these assump¬
tions he would have a fair chance of obtaining a full price for the
Liggett and Myers issue, since it would still be making an impres-

1 Many railroad bonds have proved an exception to this statement since
1933. Note, for example, that Baltimore and Ohio Railroad First 4s, due
1948, sold at 109H in 1936, although the margin over total interest charges
had long been much too small. In 1938 these bonds sold at 34%-

FIXED-VALUE INVESTMENTS

279

sive exhibit. But if the influence of the downward trend of
earnings has depressed the quotation to a large discount, then
he could decide to retain the issue rather than accept an appreci¬
able loss. In so doing he would have the great advantage of
being able to feel that the safety of investment was still not in
any real danger.

Such a policy of demanding very high safety margins would
obviously prove especially beneficial if a period of acute depres¬
sion and market unsettlement should supervene. It is not
practicable, however, to recommend this as a standard practice
for all investors, because the supply of such strongly buttressed
issues is too limited, and because, further, it is contrary to
human nature for investors to take extreme precautions against
future collapse when current conditions make for optimism. 1

Policy in Depression.—Assuming that the investor has
exercised merely reasonable caution in the choice of his fixed-
value holdings, how will he fare and what policy should he follow
in a period of depression? If the depression is a moderate
one, his investments should be only mildly affected marketwise
and still less in their intrinsic position. If conditions should
approximate those of 1930-1933, he could not hope to escape a
severe shrinkage in the quotations and considerable uneasiness
over the safety of his holdings. But any reasoned policy of
fixed-value investment requires the assumption that disturb¬
ances of the 1930-1933 amplitude are nonrecurring in their
nature and need not be specifically guarded against in the
future. If the 1921-1922 and the 1937-1938 experiences are
accepted instead as typical of the “ recurrent severe depression,”
a carefully selected investment list should give a reasonably good
account of itself in such a period. The investor should not be
stampeded into selling out holdings with a strong past record
because of a current decline in earnings. He is likely, however,
to pay more attention than usual to the question of improving
the quality of his securities, and in many cases it should be pos¬
sible to gain some benefits through carefully considered switches.

1 We must caution the reader, however, against assuming that very large
coverage of interest charges is, in itself, a complete assurance of safety. An
operating loss eliminates the margin of safety, however high it may have
been. Hence, inherent stability is an essential requirement, as we empha¬
size in our Studebaker example given in Chap. II.

280

SECURITY ANALYSIS

The experiences of the 1937-1938 “recession” offer strong
corroboration of the foregoing analysis. Practically all senior
securities that would have met our stringent requirements at the
end of 1936 came through the ensuing setback without serious
damage marketwise. But bonds that have sold at high levels
despite an inadequate over-all earnings coverage—particularly
a large number of railroad issues—suffered an enormous shrinkage
in value. (See our discussion in Chap. VII and also Appendix
Notes 11 and 13, pages 735 and 737.)

Sources of Investment Advice and Supervision. —Supervision
of securities involves the question of who should do it as well
as how to do it. Investors have the choice of various agencies
for this purpose, of which the more important are the following:

1. The investor himself.

2. His commercial bank.

3. An investment banking (or underwriting) house.

4. A New York Stock Exchange firm.

5. The advisory department of a large trust company.

6. Independent investment counsel or supervisory service.

The last two agencies charge fees for their service, whereas the
three preceding supply advice and information gratis. 1

Advice from Commercial Bankers .—The investor should not
be his own sole consultant unless he has training and experience
sufficient to qualify him to advise others professionally. In
most cases he should at least supplement his own judgment by
conference with others. The practice of consulting one’s bank
about investments is widespread, and it is undeniably of great
benefit, especially to the smaller investor. If followed con¬
sistently it would afford almost complete protection against the
hypnotic wiles of the high-pressure stock salesman and his
worthless “blue sky” flotations. 2 It is doubtful, however,
if the commercial banker is the most suitable adviser to an
investor of means. Although his judgment is usually sound,

*A growing number of Stock Exchange firms now supply investment
advice on a fee basis.

* Under S.E.C. supervision the “blue-sky flotation*' of the old school has
largely disappeared from* interstate commerce, its place being taken by
small but presumably legitimate enterprises which are sold to the public at
excessively high prices. Numerous other types of fraud are still fairly
prevalent, as can be seen from the 1938 report of the Better Business Bureau
of New York City.

FIXED-VALUE INVESTMENTS

281

his knowledge of securities is likely to be somewhat superficial,
and he cannot be expected to spare the time necessary for a
thoroughgoing analysis of his clients' holdings and problems.

Advice from Investment Banking Houses .—There are objections
of another kind to the advisory service of an investment banking
house. An institution with securities of its own to sell cannot
be looked to for entirely impartial guidance. However ethical
its aims may be, the compelling force of self-interest is bound to
affect its judgment. This is particularly true when the advice
is supplied by a bond salesman whose livelihood depends upon
persuading his customers to buy the securities that his firm has
“on its shelves. ,, It is true that the reputable underwriting
houses consider themselves as bound in some degree by a fiduciary
responsibility toward their clients. The endeavor to give them
sound advice and to sell them suitable securities arises not only
from the dictates of good business practice but more compellingly
from the obligations of a professional code of ethics.

Nevertheless, the sale of securities is not a profession but a
business and is necessarily carried on as such. Although in the
typical transaction it is to the advantage of the seller to give the
buyer full value and satisfaction, conditions may arise in which
their interests are in serious conflict. Hence it is impracticable,
and in a sense unfair, to require investment banking houses to
act as impartial advisers to buyers of securities; and, broadly
speaking, it is unwise for the investor to rely primarily upon
the advice of sellers of securities.

Advice from New York Stock Exchange Firms. —The investment
departments of the large Stock Exchange firms present a some¬
what different picture. Although they also have a pecuniary
interest in the transactions of their customers, their advice is
much more likely to be painstaking and thoroughly impartial.
Stock Exchange houses do not ordinarily own securities for
sale. Although at times they participate in selling operations,
which carry larger allowances than the ordinary market com¬
mission, their interest in pushing such individual issues is less
vital than that of the underwriting houses who actually own
them. At bottom, the investment business or bond department
of Stock Exchange firms is perhaps more important to them as a
badge of respectability than for the profits it yields. Attacks
made upon them as agencies of speculation may be answered in

282

SECURITY ANALYSIS

part by pointing to the necessary services that they render to
conservative investors. Consequently, the investor who con¬
sults a large Stock Exchange firm regarding a small bond pur¬
chase is likely to receive time and attention out of all proportion
to the commission involved. Admittedly this practice is found
profitable in the end, as a cold business proposition, because a
certain proportion of the bond customers later develop into
active stock traders. In behalf of the Stock Exchange houses
it should be said that they make no effort to persuade their
bond clients to speculate in stocks, but the atmosphere of a
brokerage office is perhaps not without its seductive influence.

Advice from Investment Counsel .—Although the idea of giving
investment advice on a fee basis is not a new one, it has only
recently developed into an important financial activity. The
work is now being done by special departments of large trust
companies, by a division of the statistical services, and by
private firms designating themselves as investment counsel or
investment consultants. The advantage of such agencies is
that they can be entirely impartial, having no interest in the
sale of any securities or in any commissions on their client's
transactions. The chief disadvantage is the cost of the service,
which averages about x /i% per annum on the principal involved.
As applied strictly to investment funds this charge would amount
to about or 3^ of the annual income, which must be con¬
sidered substantial.

In order to make their fees appear less burdensome, some
of the private investment consultants endeavor to forecast
the general course of the bond market and to advise their clients
as to when to buy or sell. It is doubtful if trading in bonds,
to catch the market swings, can be carried on successfully by
the investor. If the course of the bond market can be predicted,
it should be possible to predict that of the stock market as well,
and there would be undoubted technical advantages in trading
in stocks rather than in bonds. We are sceptical of the ability
of any paid agency to provide reliable forecasts of the market
action of either bonds or stocks. Furthermore we are convinced
that any combined effort to advise upon the choice of individual
high-grade investments and upon the course of bond prices
is fundamentally illogical and confusing. Much as the investor
would like to be able to buy at just the right time and to sell

FIXED-VALUE INVESTMENTS

283

out when prices are about to fall, experience shows that he is
not likely to be brilliantly successful in such efforts and that by
injecting the trading element into his investment operations he
will disrupt the income return'on his capital and inevitably shift
his interest into speculative directions.

It is not clear as yet whether or not advice on a fee basis will
work out satisfactorily in the field of standard high-grade invest¬
ments, because of their relatively small income return. In the
purely speculative field the objection to paying for advice is that
if the adviser knew whereof he spoke he would not need to bother
with a consultant’s duties. It may be that the profession of
adviser on securities will find its most practicable field in the
intermediate region, where the adviser will deal with problems
arising from depreciated investments, and where he will propose
advantageous exchanges and recommend bargain issues selling
considerably below their intrinsic value.

PART III

SENIOR SECURITIES WITH SPECULATIVE
FEATURES

CHAPTER XXII
PRIVILEGED ISSUES

We come now to the second major division of our revised
classification of securities, viz., bonds and preferred stocks
presumed by the buyer to be subject to substantial change
in principal value. In our introductory discussion (Chap. V)
we subdivided this group under two heads: those issues which
are speculative because of inadequate safety, and those which
are speculative because they possess a conversion or similar
privilege which makes possible substantial variations in market
price . 1

SENIOR ISSUES WITH SPECULATIVE PRIVILEGES

In addition to enjoying a prior claim for a fixed amount of
principal and income, a bond or preferred stock may also be
given the right to share in benefits accruing to the common stock.
These privileges are of three kinds, designated as follows:

1. Convertible—conferring the right to exchange the senior issue for
common stock on stipulated terms.

2. Participating—under which additional income may be paid to the
senior security holder, dependent usually upon the amount of common
dividends declared.

3. Subscription—by which holders of the bond or preferred stock may
purchase common shares, at prices, in amounts, and during periods,
stipulated.*

1 In the 1934 edition we had here a section on investment-quality senior
issues obtainable at bargain levels. Although these were plentiful in the
1931-1933 period, they have since grown very scarce—even in the market
decline of 1937-1938. To save space, therefore, we are now omitting this
section.

* There is still a fourth type of profit-sharing arrangement, of less impor-

284

SENIOR SECURITIES WITH SPECULATIVE FEATURES 285

Since the conversion privilege is the most familiar of the three,
we shall frequently use the term “convertible issues” to refer
to privileged issues in general.

Such Issues Attractive in Form.—By means of any one of
these three provisions a senior security can be given virtually
all the profit possibilities that attach to the common stock of the
enterprise. Such issues must therefore be considered as the
most attractive of all in point of form, since they permit the com¬
bination of maximum safety with the chance of unlimited
appreciation in value. A bond that meets all the requirements
of a sound investment and in addition possesses an interesting
conversion privilege would undoubtedly constitute a highly
desirable purchase.

Their Investment Record Unenviable: Reasons. —Despite
this impressive argument in favor of privileged senior issues as a
form of investment, we must recognize that actual experience
with this class has not been generally satisfactory. For this
discrepancy between promise and performance, reasons of two
different kinds may be advanced.

The first is that only a small fraction of the privileged issues
have actually met the rigorous requirements of a sound invest¬
ment. The conversion feature has most often been offered to

tance than the three just described, which made its first appearance in the
1928-1929 bull market. This is the so-called '‘optional” bond or preferred
stock. The option consists of taking interest or dividend payments in a
fixed amount of common stock ( i.e ., at a fixed price per share) in lieu of
cash.

For example, Commercial Investment Trust $6 Convertible Preference,
Optional Series of 1929, gave the holder the option to take his dividend at
the annual rate of one-thirteenth share of common instead of $6 in cash.
This was equivalent to a price of $78 per share for the common, which
meant that the option would be valuable whenever the stock was selling
above 78. Similarly, Warner Brothers Pictures, Inc., Optional 6% Con¬
vertible Debentures, due 1939, issued in 1929, gave the owner the option to
take his interest payments at the annual rate of one share of common stock
instead of $60 in cash.

It may be said that this optional arrangement is a modified form of
conversion privilege, under which the interest or dividend amounts are made
separately convertible into common stock, in most, possibly all, of these
issues, the principal is convertible as well. The separate convertibility of
the income payments adds somewhat, but not a great deal, to the attractive¬
ness of the privilege.

286

SECURITY ANALYSIS

compensate for inadequate security. 1 This weakness was most
pronounced during the period of greatest vogue for convertible
issues, between 1926 and 1929. 2 During these years it was
broadly true that the strongly entrenched industrial enterprises
raised money through sales of common stock, whereas the
weaker—or weakly capitalized—undertakings resorted to privi¬
leged senior securities.

The second reason is related to the conditions under which
profit may accrue from the conversion privilege. Although there
is indeed no upper limit to the price that a convertible bond
may reach, there is a very real limitation on the amount of
profit that the holder may realize while still maintaining an
investment position. After a privileged issue has advanced
with the common stock, its price soon becomes dependent in
both directions upon changes in the stock quotation, and
to that extent the continued holding of the senior issue
becomes a speculative operation. An example will make this
clear:

Let us assume the purchase of a high-grade 3 Yz% bond at par,
convertible into two shares of common for each $100 bond
(i.e., convertible into common stock at 50). The common stock
is selling at 45 when the bond is bought.

First stage: (1) If the stock declines to 35, the bond may remain
close to par. This illustrates the pronounced technical advan¬
tage of a convertible issue over the common stock. (2) If the
stock advances to 55, the price of the bond will probably rise
to 115 or more. (Its “ immediate conversion value ” would be
110, but a premium would be justified because of its advantage

1 The Report of the Industrial Securities Committee of the Investment
Bankers Association of America for 1927 quotes, presumably with approval,
a suggestion that since a certain percentage of the senior securities of moder¬
ate-sized industrial companies “are liable to show substantial losses over a
period of five or ten years,” investors therein should be given a participation
in future earnings through a conversion or other privilege to compensate for
this risk. See Proceedings of the Sixteenth Annual Convention of the Invest¬
ment Bankers Association of America , pp. 144-145, 1927.

* Prior to the appearance on Feb. 16, 1939, of Release No. 208 {Statistical
Series) of the S.E.C., no comprehensive compilation of the dollar volume of
privileged issues has been made and regularly maintained. That release
gave data on a quarterly basis for the period from Apr. 1, 1937, through
Dec. 31, 1938, and additional data have since been published quarterly by
the S.E.C. Further evidence of the volume of this type of financing over a
much longer period is presented in Appendix Note 35, p. 762.

SENIOR SECURITIES WITH SPECULATIVE FEATURES 287

over the stock.) This illustrates the undoubted speculative
possibilities of such a convertible issue.

Second stage: The stock advances further to 65. The con¬
version value of the bond is how 130, and it will sell at that
figure, or slightly higher. At this point the original purchaser
is faced with a problem. Within wide limits, the future price
of his bond depends entirely upon the course of the common
stock. In order to seek a larger profit he must risk the loss
of the profit in hand, which in fact constitutes a substantial
part of the present market value of his security. (A drop in
the price of the common could readily induce a decline in the bond
from 130 to 110.) If he elects to hold the issue, he places him¬
self to a considerable degree in the position of the stockholders,
and this similarity increases rapidly as the price advances
further. If, for example, he is still holding the bond at a level
say of 180 (90 for the stock), he has for all practical purposes
assumed the status and risks of a stockholder.

Unlimited Profit in Such Issues Identified with Stockholder’s
Position .—The unlimited profit possibilities of a privileged
issue are thus in an important sense illusory. They must be
identified not with the ownership of a bond or preferred stock
but with the assumption of a common stockholder’s position—
which any holder of a nonconvertible may effect by exchanging
his bond for a stock. Practically speaking, the range of profit
possibilities for a convertible issue, although still maintaining
the advantage of an investment holding , must usually be limited
to somewhere between 25 and 35% of its face value. For this
reason original purchasers of privileged issues do not ordinarily
hold them for more than a small fraction of the maximum market
gains scored by the most successful among them, and conse¬
quently they do not actually realize these very large possible
profits. Thus the profits taken may not offset the losses occa¬
sioned by unsound commitments in this field.

Examples of Attractive Issues.—The two objections just dis¬
cussed must considerably temper our enthusiasm for privileged
senior issues as a class, but they by no means destroy their
inherent advantages nor the possibilities of exploiting them with
reasonable success. Although most new convertible offerings
may have been inadequately secured, 1 there are fairly frequent

1 This criticism does not apply to convertible bonds issued from 1933 to
date, the majority of which meet our investment standards.

288

SECURITY ANALYSIS

exceptions to the rule, and these exceptions should be of prime
interest to the alert investor. We append three leading examples
of such opportunities, taken from the utility, the railroad, and the
industrial fields.

1. Commonwealth Edison Company Convertible Debenture 3%s,
Due 1958.—These bonds were offered to shareholders in June
and September 1938 at par. The statistical exhibit of the com¬
pany gave every assurance that the debentures were a sound
commitment at that price. They were convertible into 40 shares
of common stock until maturity or prior redemption.

In September 1938 the debentures could have been bought on
the New York Stock Exchange at par when the stock was selling
at 2434* At these prices the bonds and stock were selling very
close to a parity, and a slight advance in the price of the stock
would enable the holder of the bond to sell at a profit. Less
than a year later (July 1939) the stock had risen to 31%, and
the bonds to 124%.

2. Chesapeake and Ohio Railway Company Convertible 5s, Due
1946.—These bonds were originally offered to shareholders
in June 1916. They were convertible into common stock at 75
until April 1, 1920; at 80 from the latter date until April 1,
1923; at 90 from the latter date until April 1, 1926; and at 100
from the latter date until April 1, 1936.

Late in 1924 they could have been bought on a parity basis
( i.e ., without payment of a premium for the conversion privilege)
at prices close to par. Specifically, they sold on November 28,
1924, at 101 when the stock sold at 91. At that time the com¬
pany's earnings were showing continued improvement and indi¬
cated that the bonds were adequately secured. (Fixed charges
were covered twice in 1924.) The value of the conversion
privilege was shown by the fact that the stock sold at 131 in the
next year, making the bonds worth 145.

3. Rand Kardex Bureau , Inc., 5%s, Due 1931.—These bonds
were originally offered in December 1925 at 99%. They carried
stock-purchase warrants (detachable after January 1, 1927)
entitling the holder to purchase 22% shares of Class A common
at $40 per share during 1926, at $42.50 per share during 1927, at
$45 per share during 1928, at $47.50 per share during 1929, and at
$50 per share during 1930. (The Class A stock was in reality a
participating preferred issue.) The bonds could be turned in at

SENIOR SECURITIES WITH SPECULATIVE FEATURES 289

par in payment for the stock purchased under the warrants, a
provision that virtually made the bonds convertible into the
stock.

The bonds appeared to be adequately secured. The previous
exhibit (based on the earnings of the predecessor companies)
showed the following coverage for the interest on the new bond
issue:

Year

Number of Times Ii

1921 (depression year)

1.7

1922 (depression year)

2.3

1923

6.7

1924

7.2

1925 (9 months)

12.2

Net current assets exceed twice the face value of the bond issue.

When the bonds were offered to the public, the Class A stock
was quoted at about 42, indicating an immediate value for the
stock-purchase warrants. The following year the stock advanced
to 53, and the bonds to 1303^. In 1927 (when Rand Kardex
merged with Remington Typewriter) the stock advanced to
76, and the bonds to 190.

Example of an Unattractive Issue.—By way of contrast with
these examples we shall supply an illustration of a superficially
attractive but basically unsound convertible offering, such as
characterized the 1928-1929 period.

National Trade Journals, Inc., 6% Convertible Notes , Due
1938.—The company was organized in February 1928 to acquire
and publish about a dozen trade journals. In November 1928
it sold $2,800,000 of the foregoing notes at 97H- The notes were
initially convertible into 27 shares of common stock (at $37.03
per share) until November 1, 1930; into 25 shares (at $40 a
share) from the latter date until November 1, 1932; and at prices
that progressively increased to $52.63 a share during the last
two years of the life of the bonds.

These bonds could have been purchased at the time of issuance
and for several months thereafter at prices only slightly above
their parity value as compared with the market value of the
equivalent stock. Specifically, they could have been bought
at 97 on November 30, when the stock sold at 34 which
meant that the stock needed to advance only two points to assure
a profit on conversion.

290

SECURITY ANALYSIS

However, at no time did the bonds appear to be adequately
secured, despite the attractive picture presented in the offering
circular. The circular exhibited “estimated” earnings of the
predecessor enterprise based on the 3Yi years preceding, which
averaged 4.16 times the charges on the bond issue. But close to
half of these estimated earnings were expected to be derived from
economies predicted to result from the consolidation in the way
of reduction of salaries, etc. The conservative investor would
not be justified in taking these “earnings” for granted, par¬
ticularly in a hazardous and competitive business of this type,
with a relatively small amount of tangible assets.

Eliminating the estimated “earnings” mentioned in the
preceding paragraph the exhibit at the time of issuance and there¬
after was as follows:

Year

Price range
of bonds

Price range
of stock

Prevailing

conversion

price

Times

interest

earned

Earned per
share on

common

1925

1926

1927

1928

1929

1930

1931

1.73*
2.52*
2.80*

1.691

1.861
0.09f

Receivership

SO 78*

1 84*

2 20*
1.95

1 04
1.68(d)

100 -97K
99 -50

42 -10

10 y 2 - 5

35%-30
34%— 5

6 K- X

S37.03

37.03

37.03-S40

40.00

* Predecessor enterprise. Pre-share figures are after estimating federal taxes,
t Actual earnings for last 10 months of 1928 and succeeding calendar years.

Receivers were appointed in June 1931. The properties were
sold in August of that year, and bondholders later received about
8 Yt cents on the dollar.

Principle Derived. —From these contrasting instances an
investment principle may be developed that should afford a
valuable guide to the selection of privileged senior issues. The
principle is as follows: A privileged senior issue } selling close to
or above face value , must meet the requirements either of a straight
fixed-value investment or of a straight common-stock speculation ,
and it must be bought with one or the other qualification clearly in
view .

The alternative given supplies two different approaches to
the purchase of a privileged security. It may be bought as a

SENIOR SECURITIES WITH SPECULATIVE FEATURES 291

sound investment with an incidental chance of profit through an
enhancement of principal, or it may be bought 'primarily as an
attractive form of speculation in the common stock. Generally
speaking, there should be no middle ground. The investor
interested in safety of principal should riot abate his requirements
in return for a conversion privilege; the speculator should not be
attracted to an enterprise of mediocre promise because of the
pseudo-security provided by the bond contract.

Our opposition to any compromise between the purely invest¬
ment and the admittedly speculative attitude is based primarily
on subjective grounds. Where an intermediate stand is taken,
the result is usually confusion, clouded thinking and self-decep¬
tion. The investor who relaxes his safety requirements to
obtain a profit-sharing privilege is frequently not prepared,
financially or mentally, for the inevitable loss if fortune should
frown on the venture. The speculator who wants to reduce
his risk by operating in convertible issues is likely to find his
primary interest divided between the enterprise itself and the
terms of the privilege, and he will probably be uncertain in
his own mind as to whether he is at bottom a stockholder or a
bondholder. (Privileged issues selling at substantial discounts
from par are not in general subject to this principle, since they
belong to the second category of speculative senior securities
to be considered later.)

Reverting to our examples, it will be seen at once that the
Commonwealth Edison 3}^s could properly have been purchased
as an investment without any regard to the conversion feature.
The strong possibility that this privilege would be of value made
the bond almost uniquely attractive at the time of issuance.
Somewhat similar statements could be made with respect to the
Chesapeake and Ohio and the Rand Kardex bonds. Any of
these three securities should also have been attractive to a
speculator who was persuaded that the related common stock
was due for an advance in price.

On the other hand the National ^rade Journals Debentures
could not have passed stringent qualitative and quantitative
tests of safety. Hence they should properly have been of
interest only to a person who had full confidence in the future
value of the stock. It is hardly likely, however, that most
cf the buying of this issue was motivated by the primary desire

292

SECURITY ANALYSIS

to invest or speculate in the National Trade Journals common
stock, but it was based rather on the attractive terms of the
conversion privilege and on the feeling that the issue was “ fairly
safe” as a bond investment. It is precisely this compromise
between true investment and true speculation that we disapprove,
chiefly because the purchaser has no clear-cut idea of the purpose
of his commitment or of the risk that he is incurring.

Rules Regarding Retention or Sale. —Having stated a basic
principle to guide the selection of privileged issues, we ask next
what rules can be established regarding their subsequent reten¬
tion or sale. Convertibles bought primarily as a form of com¬
mitment in the common stock may be held for a larger profit
than those acquired from the investment standpoint. If a
bond of the former class advances from 100 to 150, the large
premium need not in itself be a controlling reason for selling
out; the owner must be guided rather by his views as to whether
or not the common stock has advanced enough to justify taking
his profit. But when the purchase is made primarily as a safe
bond investment, then the limitation on the amount of profit
that can conservatively be waited for comes directly into play.
For the reasons explained in detail above, the conservative
buyer of privileged issues will not ordinarily hold them for
more than a 25 to 35% advance. This means that a really
successful investment operation in the convertible field does not
cover a long period of time. Hence such issues should be bought
with the 'possibility of long-term holding in mind but with the
hope that the potential profit will be realized fairly soon.

The foregoing discussion leads to the statement of another
investment rule, viz.:

In the typical casc } a convertible bond should not be converted
by the investor. It should be either held or sold.

It is true that the object of the privilege is to bring about
such conversion when it seems advantageous. If the price
of the bond advances substantially, its current yield will shrink
to an unattractive figure, and there is ordinarily a substantial
gain in income to be realized through the exchange into stock.
Nevertheless when the investor does exchange his bond into the
stock, he abandons the priority and the unqualified claim to
principal and interest upon which the purchase was originally
premised. If after the conversion is made things should go

SENIOR SECURITIES WITH SPECULATIVE FEATURES 293

badly, his shares may decline in value far below the original cost
of his bond, and he will lose not only his profit but part of his
principal as well.

Moreover he is running the -risk of transforming himself—
generally, as well as in the specific instances—from a bond
investor into a stock speculator. It must be recognized that
there is something insidious about even a good convertible
bond; it can easily prove a costly snare to the unwary. To
avoid this danger the investor must cling determinedly to a
conservative viewpoint. When the price of his bond has passed
out of the investment range, he must sell it; most important of
all, he must not consider his judgment impugned if the bond
subsequently rises to a much higher level. The market behavior
of the issue, once it has entered the speculative range, is no more
the investor’s affair than the price gyrations of any speculative
stock about which he knows nothing.

If the course of action here recommended is followed by
investors generally, the conversion of bonds would be brought
about only through their purchase for this specific purpose by
persons who have decided independently to acquire the shares
for either speculation or supposed investment. 1 The arguments
against the investor’s converting convertible issues apply with
equal force against his exercising stock-purchase warrants
attached to bonds bought for investment purposes.

A continued policy of investment in privileged issues would,
under favorable conditions, require rather frequent taking of
profits and replacement by new securities not selling at an
excessive premium. More concretely, a bond bought at 100
would be sold, say, at 125 and be replaced by another good con¬
vertible issue purchasable at about par. It is not likely that
satisfactory opportunities of this kind will be continuously
available or that the investor would have the means of locating
all those that are at hand. But the trend of financing in recent
years offers some promise that a fair number of really attractive
convertibles may again make their appearance. Following the
1926-1929 period, marked by a flood of privileged issues generally
of poor quality, and the 1930-1934 period, in which the emphasis

1 In actual practice, conversions often result also from arbitrage oper¬
ations involving the purchase of the bond and the simultaneous sale of the
stock at a price slightly higher than the “conversion parity.”

294

SECURITY ANALYSIS

on safety caused the virtual disappearance of conversion privileges
from new bond offerings, there has been a definite swing of the
pendulum towards a middle point, where participating features
are at times employed to facilitate the sale of sound bond offer¬
ings. 1 Most of those sold between 1934 and 1939 either carried
very low coupon rates or immediately jumped to a prohibitive
premium. But we incline to the view that the discriminating
and careful investor is again likely to find a reasonable number of
attractive opportunities presented in this field.

1 For data regarding the relative frequency of privilege issues between 1925
and 1938, see Appendix Note 35, p. 762, and the S.E.C. statistical releases
referred to in a footnote on page 286.

CHAPTER XXIII

TECHNICAL CHARACTERISTICS OF PRIVILEGED
SENIOR SECURITIES

In the preceding chapter privileged senior issues were con¬
sidered in their relationship to the broader principles of invest¬
ment and speculation. To arrive at an adequate knowledge
of this group of securities from their practical side, a more
intensive discussion of their characteristics is now in order.
Such a study may conveniently be carried on from three succes¬
sive viewpoints: (1) considerations common to all three types
of privilege—conversion, participation, and subscription (i.e.,
“warrant”); (2) the relative merits of each type, as compared
with the others; (3) technical aspects of each type, considered
by itself. 1

CONSIDERATIONS GENERALLY APPLICABLE TO PRIVILEGED

ISSUES

The attractiveness of a profit-sharing feature depends upon
two major but entirely unrelated factors: (1) the terms of the
arrangement and (2) the prospects of profits to share. To use a
simple illustration:

Company A Company B

4% bond selling at 100 4% bond selling at 100

Convertible into stock at 50 (Le., two Convertible into stock at 33H (i.e.,

shares of stock for a $100 bond) three shares of stock for a $100

bond)

Stock selling at 30 Stock selling at 30

Terms of the Privilege vs. Prospects for the Enterprise. —The

terms of the conversion privilege are evidently more attractive
in the case of Bond B ; for the stock need advance only a little
more than 3 points to assure a profit, whereas Stock A must
advance over 20 points to make conversion profitable. Never-

1 This subject is treated at what may appear to be disproportionate length
because of the growing importance of privileged issues and the absence of
thoroughgoing discussion thereof in the standard descriptive textbooks.

295

296

SECURITY ANALYSIS

theless, it is quite possible that Bond A may turn out to be the
more advantageous purchase. For conceivably Stock B may
fail to advance at all while Stock A may double or triple in price.

As between the two factors, it is undoubtedly true that it
is more profitable to select the right company than to select
the issue with the most desirable terms . There is certainly
no mathematical basis on which the attractiveness of the enter¬
prise may be offset against the terms of the privilege, and a
balance struck between these two entirely dissociated elements
of value. But in analyzing privileged issues of the investment
grade, the terms of the privilege must receive the greater atten¬
tion, not because they are more important but because they
can be more definitely dealt with. It may seem a comparatively
easy matter to determine that one enterprise is more promising
than another. But it is by no means so easy to establish that
one common stock at a given price is clearly preferable to another
stock at its current price.

Reverting to our example, if it were quite certain, or even
reasonably probable, that Stock A is more likely to advance to 50
than Stock B to advance to 33, then both issues would not be
quoted at 30. Stock A } of course, would be selling higher. The
point we make is that the market price in general reflects already
any superiority that one enterprise has demonstrated over
another. The investor who prefers Bond A because he expects
its related stock to rise a great deal faster than Stock B , is exer¬
cising independent judgment in a field where certainty is lacking
and where mistakes are necessarily frequent. For this reason
we doubt that a successful policy of buying privileged issues
from the investment approach can be based primarily upon the
purchaser's view regarding the future expansion of the profits of
the enterprise. (In stating this point we are merely repeat¬
ing a principle previously laid down in the field of fixed-value
investment.)

Where the speculative approach is followed, i.e ., where the
issue is bought primarily as a desirable method of acquiring an
interest in the stock, it would be quite logical, of course, to assign
dominant weight to the buyer's judgment as to the future of the
company.

Three Important Elements. 1 . Extent of the Privilege . —In
examining the terms of a profit-sharing privilege, three component
elements are seen to enter. These are:

SENIOR SECURITIES WITH SPECULATIVE FEATURES 297

а. The extent of the profit-sharing or speculative interest per dollar of
investment.

б. The closeness of the privilege to a realizable profit at the time of purchase.

e. The duration of the privilege.

The amount of speculative interest attaching to a convertible
or warrant-bearing senior security is equal to the current market
value of the number of shares of stock covered by the privilege.
Other things being equal, the larger the amount of the specu¬
lative interest per dollar of investment the more attractive the
privilege.

j Examples: Rand Kardex 5j^s, previously described, carried
warrants to buy 22shares of Class A stock initially at 40.
Current price of Class A stock was 42. The “ speculative
interest” amounted to 22X 42, or $945 per $1,000 bond.

Reliable Stores Corporation 6s, offered in 1927, carried war¬
rants to buy only 5 shares of common stock initially at 10.
Current price of the common was 12. Hence the “speculative
interest” amounted to 5 X 12, or only $60 per $1,000 bond.

Intercontinental Rubber Products Co. 7s offered an extra¬
ordinary example of a large speculative interest attaching to a
bond. As a result of peculiar provisions surrounding their
issuance in 1922, each $1,000 note was convertible into 100
shares of stock and also carried the right to purchase 400 addi¬
tional shares at 10. When the stock sold at 10 in 1925, the
speculative interest per $1,000 note amounted to 500 X 10, or
$5,000. If the notes were then selling, say, at 120, the specula¬
tive interest would have equalled 417 % of the bond investment—
or 70 times as great as in the case of the Reliable Stores offering.

The practical importance of the amount of speculative interest
can be illustrated by the following comparison, covering the
three examples above given.

Item

Reliable
Stores Gs

Rand Kardex
5Ks

Interconti¬
nental Rubber
7s

Number of shares covered by
each $1,000 bond.

22H

500

Base price.

$10.00

$ 40.00

$ 10.00

Increase in value of bond
when stock advances:

25% above base price....

12.50

225.00

1,250.00

50% above base price....

25.00

450.00

2,500.00

100% above base price....

50.00

5,000.00

298

SECURITY ANALYSIS

In the case of convertible bonds the speculative interest
always amounts to 100% of the bond at par when the stock
sells at the conversion price. Hence in these issues our first
and second component elements express the same fact. If a
bond selling at par is convertible into stock at 50, and if the
stock sells at 30, then the speculative interest amounts to 60%
of the commitment, which is the same thing as saying that the
current price of the stock is 60% of that needed before conversion
would be profitable. Stock-purchase-warrant issues disclose no
such fixed relationship between the amount of the speculative
interest and the proximity of this interest to a realizable profit.
In the case of the Reliable Stores 6s, the speculative interest was
very small, but it showed an actual profit at the time of issuance,
since the stock was selling above the subscription price.

Significance of Call on Large Number of Shares at Low Price .—It
may be said parenthetically that a speculative interest in a large
number of shares selling at a low price is technically more
attractive than one in a smaller number of shares selling at a
high price. This is because low-priced shares are apt to fluctuate
over a wider range percentagewise than higher priced stocks.
Hence if a bond is both well secured and convertible into many
shares at a low price, it will have an excellent chance for very
large profit without being subject to the offsetting risk of greater
loss through a speculative dip in the price of the stock.

For example, as a matter of form of privilege, the Ohio Copper
Company 7s, due 1931, convertible into 1,000 shares of stock
selling at $1, had better possibilities than the Atchison, Topeka
and Santa Fe Convertible 4J^s, due 1948, convertible into 6
shares of common, selling at 166^, although in each case the
amount of speculative interest equalled $1,000 per bond. As it
turned out, Ohio Copper stock advanced from less than $1 a
share in 1928 to 4% in 1929, making the bond worth close to
500% of par. It would have required a rise in the price of
Atchison from 166 to 800 to yield the same profit on the con¬
vertible 43^s, but the highest price reached in 1929 was under 300.

In the case of participating issues , the extent of the profit-
sharing interest would ordinarily be considered in terms of the
amount of extra income that may conceivably be obtained as a
result of the privilege. A limited extra payment ( e.g ., Bayuk
Cigars, Inc., 7% Preferred, which may receive not more than

SENIOR SECURITIES WITH SPECULATIVE FEATURES 299

1% additional) is of course less attractive than an unlimited
participation ( e.g ., White Rock Mineral Springs Company 5%
Second Preferred, which received a total of 2634% in 1930).

2 and 3. Closeness and Duration of the Privilege .—The implica¬
tions of the second and third factors in valuing a privilege are
readily apparent. A privilege having a long period to run is in
that respect more desirable than one expiring in a short time.
The nearer the current price of the stock to the level at which
conversion or subscription becomes profitable the more attrac¬
tive docs the privilege become. In the case of a participation
feature, it is similarly desirable that the current dividends or
earnings on the common stock should be close to the figure at
which the extra distribution on the senior issue commences.

By “ conversion price” is meant the price of the common
stock equivalent to a price of 100 for the convertible issue. If a
preferred stock is convertible into 1% as many shares of com¬
mon, the conversion price of the common is therefore 60. The
term “conversion parity,” or “conversion level,” may be used
to designate that price of the common which is equivalent to a
given quotation for the convertible issue, or vice versa. It
can be found by multiplying the price of the convertible issue
by the conversion price of the common. If the preferred stock
just mentioned is selling at 90, the conversion parity of the
common becomes 60 X 90% = 54. This means that to a buyer
of the preferred at 90 an advance in the common above 54 will
create a realizable profit. Conversely, if the common sold at 66,
one might say that the conversion parity of the preferred is 110.

The “closeness” of the privilege may be stated arithmetically
as the ratio between the market price and the conversion parity
of the common stock. In the foregoing example, if the common
is selling at 54 and the preferred at 110 (equivalent to 66 for
the common), the “index of closeness” becomes 54 -f* 66, or 0.82.

COMPARATIVE MERITS OF THE THREE TYPES OF PRIVILEGES

From the theoretical standpoint, a participating feature—
unlimited in time and possible amount—is the most desirable
type of profit-sharing privilege. This arrangement enables
the investor to derive the specific benefit of participation in
profits (viz., increased income) without modifying his original
position as a senior-security holder. These benefits may be

300

SECURITY ANALYSIS

received over a long period of years. By contrast, a conversion
privilege can result in higher income only through actual exchange
into the stock and consequent surrender of the senior position.
Its real advantage consists, therefore, only of the opportunity
to make a profit through the sale of the convertible issue at the
right time. Similarly the benefits from a subscription privilege
may conservatively be realized only through sale of the warrants
(or by the subscription to and prompt sale of the stock). If the
common stock is purchased and held for permanent income, the
operation involves the risking of additional money on a basis
entirely different from the original purchase of the senior issue.

Example of Advantage of Unlimited Participation Privilege.—
An excellent practical example of the theoretical advantages
attaching to a well-entrenched participating security is afforded
by Westinghouse Electric and Manufacturing Company Pre¬
ferred. This issue is entitled to cumulative prior dividends of
$3.50 per annum (7% on $50 par) and in addition participates
equally per share with the common in any dividends paid on the
latter in excess of $3.50. As far back as 1917 Westinghouse
Preferred could have been bought at 52}^, representing an
attractive straight investment with additional possibilities
through its participating feature. In the ensuing 15 years to
1932 a total of about $7 per share was disbursed in extra dividends
above the basic 7 %. In the meantime an opportunity arose to
sell out at a large profit (the high price being 284 in 1929), which
corresponded to the enhancement possibilities of a convertible
or subscription-warrant issue. If the stock was not sold, the
profit was naturally lost in the ensuing market decline. But the
investor’s original position remained unimpaired, for at the low
point of 1932 the issue was still paying the 7% dividend and
selling at 52J^—although the common had passed its dividend
and had fallen to 15^.

In this instance the investor was able to participate in the
surplus profits of the common stock in good years while main¬
taining his preferred position, so that, when the bad years came,
he lost only his temporary profit . Had the issue been convertible
instead of participating, the investor could have received the
higher dividends only through converting and would later have
found the dividend omitted on his common shares and their value
fallen far below his original investment.

SENIOR SECURITIES WITH SPECULATIVE FEATURES 301

Participating Issues at Disadvantage, Marketwise. —Although
from the standpoint of long-pull-investment holding, participat¬
ing issues are theoretically the most desirable, they may behave
somewhat less satisfactorily in a.major market upswing than do
convertible or subscription-warrant issues. During such a
period a participating senior security may regularly sell below
its proper comparative price. In the case of Westinghouse
Preferred, for example, its price during 1929 was usually from
5 to 10 points lower than that of the common, although its
intrinsic value per share could not be less than that of the junior
stock. 1

The reason for this phenomenon is as follows: The price of the
common stock is made largely by speculators interested chiefly in
quick profits, to secure which they need an active market. The
preferred stock, being closely held, is relatively inactive. Con¬
sequently the speculators are willing to pay several points more
for the inferior common issue simply because it can be bought
and sold more readily and because other speculators are likely
to be willing to pay more for it also.

The same anomaly arises in the case of closely held common
stocks with voting power, compared with the more active non¬
voting issue of the same company. American Tobacco B and
Liggett and Myers Tobacco B (both non voting) have for years
sold higher than the voting stock. A similar situation formerly
existed in the two common issues of Bethlehem Steel, Pan
American Petroleum and others. 2 The paradoxical principle
holds true for the securities market generally that in the absence
of a special demand relative scarcity is likely to make for a lower
rather than a higher price.

1 A much greater price discrepancy of this kind existed in the case of
White Rock Mineral Springs Participating Preferred and common during
1929 and 1930. Because of this market situation, holders of nearly all the
participating preferred shares accepted an offer to exchange into common
stock, although this meant no gain in income and the loss of their senior
position.

* The persistently wide spread between the market prices for R. J.
Reynolds Tobacco Company common and Class B stocks rests on the
special circumstance that officers and employees of the company who own
the common stock enjoy certain profit-sharing benefits not accorded to
holders of the Class B stock. The New York Stock Exchange will no longer
list nonvoting common stocks, nor are these permitted to be issued in
reorganizations effected under Chap. X of the 1938 Bankruptcy Act.

302

SECURITY ANALYSIS

In cases such as Westinghouse and American Tobacco the
proper corporate policy would be to extend to the holder of the
intrinsically more valuable issue the privilege of exchanging it
for the more active but intrinsically inferior issue. The White
Rock company actually took this step. Although the holders of
the participating preferred might make a mistake in accepting
such an offer, they cannot object to its being made to them, and
the common stockholders may gain but cannot lose through its
acceptance.

Relative Price Behavior of Convertible and Warrant-bearing
Issues.—From the standpoint of price behavior under favorable
market conditions the best results are obtained by holders of
senior securities with detachable stock-purchase warrants.

To illustrate this point we shall compare certain price relation¬
ships shown in 1929 between four privileged issues and the corre¬
sponding common stocks. The issues are as follows:

1. Mohawk Hudson Power Corporation 7% Second Preferred, carrying
warrants to buy 2 shares of common at 50 for each share of preferred.

2. White Sewing Machine Corporation 6% Debentures, due 1936,
carrying warrants to buy 2>£ shares of common stock for each $100 bond.

3. Central States Electric Corporation 6% Preferred, convertible into
common stock at $118 per share.

4. Independent Oil and Gas Company Debentures 6s, due 1939, con¬
vertible into common stock at $32 per share.

Senior issue

Market
price of
common

Con¬
version
or sub¬
scription
price of
common

Realizable
value of
senior issue
based on
privilege
(conversion
or subscrip¬
tion parity)

Amount by
which senior
issue sold
above parity,
(“pre¬
mium”),
points

Mohawk Hudson 2d Pfd.

523*

163*

105

White Sewing Machine 6s.

123Ht

973*

Central States Electric Pfd .

110

118

Independent Oil & Gas 6s .

105

* Consisting of 107 for the preferrod stock, ex-warrants, plus 50 for the warrants,
t Consisting of 98K for the bonds, ex-warrants, plus 25 for the warrants.

The foregoing table shows in striking fashion that in specula¬
tive markets issues with purchase warrants have a tendency to sell
at large premiums in relation to the common-stock price and

SENIOR SECURITIES WITH SPECULATIVE FEATURES 303

that these premiums are much greater than in the case of similarly
situated convertible issues.

Advantage of Separability of Speculative Component.—This

advantage of subscription-warrant issues is due largely to the
fact that their speculative component (t.e., the subscription
warrant itself) can be entirely separated from their investment
component (i.e., the bond or preferred stock ex-warrants).
Speculators are always looking for a chance to make large profits
on a small cash commitment. This is a distinguishing character¬
istic of stock option warrants, as will be shown in detail in our
later discussion of these instruments. In an advancing market,
therefore, speculators bid for the warrants attached to these
privileged issues, and hence they sell separately at a substantial
price even though they may have no immediate exercisable value.
These speculators greatly prefer buying the option warrants to
buying a corresponding convertible bond , because the latter
requires a much larger cash investment per share of common
stock involved. 1 It follows, therefore, that the separate market
values of the bond plus the option warrant (which combine to
make the price of the bond “with warrants”) may considerably
exceed the single quotation for a closely similar convertible issue.

Second Advantage of Warrant-bearing Issues. —Subscription-
warrant issues have a second point of superiority, in respect to
callable provisions. A right reserved by the corporation to
redeem an issue prior to maturity must in general be considered
as a disadvantage to the holder; for presumably it will be exercised
only when it is to the benefit of the issuer to do so, which means
usually that the security would otherwise sell for more than the
call price. 2 A callable provision, unless at a very high premium,

1 Note that the Independent Oil and Gas bonds represented a com¬
mitment of $33.60 per share of common, whereas the White Sewing Machine
warrants involved a commitment of only $10 per share of common. But
the former meant ownership of either a fixed claim or a share of stock,
whereas the latter meant only the right to buy a share of stock at a price above
the market.

*The callable feature may be—and recently has been—an unfavorable
element of great importance even in “straight” non-convertible bonds.

In a few cases a callable feature works out to the advantage of the
holder, by facilitating new financing which involves the redemption of the
old issue at a price above the previous market. But the same result could
be obtained, if there were no right to call, by an offer to “buy in” the

304

SECURITY ANALYSIS

might entirely vitiate the value of a participating privilege.
For with such a provision there would be danger of redemption
as soon as the company grew prosperous enough to place the
issue in line for extra distributions. 1 In some cases participating
issues that are callable are made convertible as well, in order to
give them a chance to benefit from any large advance in the
market price of the common that may have taken place up to
the time of call. (See for examples: National Distillers Products
Corporation $2.50 Cumulative Participating Convertible Pre¬
ferred; 2 Kelsey-Hayes Wheel Company $1.50 Participating Con¬
vertible Class A stock.) Participating bonds are generally
limited in their right to participate in surplus earnings and are
commonly callable. (See White Sewing Machine Corporation
Participating Debenture 6s, due 1940; United Steel Works
Corporation Participating 6J^s, Series A, due 1947; neither of
which is convertible.) Sometimes participating issues are pro¬
tected against loss of the privilege through redemption by setting
the call price at a very high figure. Something of this sort was
apparently attempted in the case of San Francisco Toll-Bridge
Company Participating 7s, due 1942, which were callable at 120
through November 1, 1933, and at lower prices thereafter.
Celluloid Corporation Participating Second Preferred is callable
at 150, whereas Celanese Corporation Participating First Pre¬
ferred is noncallable.

Another device to prevent vitiating the participating privilege
through redemption is to make the issue callable at a price that
may be directly dependent upon the value of the participating

security. This was done in the case of United States Steel Corporation 5s,
due 1951, which were not callable but were bought in at 110.

1 Dewing cites the case of Union Pacific Railroad—Oregon Short Line
Participating 4s, issued in 1903, which were secured by the pledge of North¬
ern Securities Company stock. The bondholders had the right to partici¬
pate in any dividends in excess of 4% declared on the deposited collateral.
The bonds were called at 102% just at the time when participating dis¬
tributions seemed likely to occur. See Arthur S. Dewing, A Study of
Corporation Securities f p. 328, New York, 1934.

* Coincident with the rise of the common stock from 16% to 124% in
1933, all the National Distillers Preferred Stock was converted in that year.
Nearly all the conversions were precipitated by a change in the conversion
rate after June 30, 1933. The small balance was converted as a result of
the calling of issue at 40 and dividend in August.

SENIOR SECURITIES WITH SPECULATIVE FEATURES 306

privilege. For example, Siemens and Halske Participating
Debentures, due in 2930, are callable after April 1, 1942, at the
average market price for the issue during the six months preceding
notice of redemption but at not less than the original issue price
(which was over 230% of the par value). The Kreuger and Toll
5% Participating Debentures had similar provisions.

Even in the case of a convertible issue a callable feature is
technically a serious drawback because it may operate to reduce
the duration of the privilege. Conceivably a convertible bond
may be called just when the privilege is about to acquire real
value. 1

But in the case of issues with stock-purchase warrants, the
subscription privilege almost invariably runs its full time even
though the senior issue itself may be called prior to maturity.
If the warrant is detachable, it simply continues its separate
existence until its own expiration date. Frequently, the sub¬
scription privilege is made “nondetachable”; t.c., it can be exer¬
cised only by presentation of the senior security. But even in
these instances, if the issue should be redeemed prior to the
expiration of the purchase-option period, it is customary to give
the holder a separate warrant running for the balance of the time
originally provided.

Example: Prior to January 1, 1934, United Aircraft and
Transport Corporation had outstanding 150,000 shares of 6%
Cumulative Preferred stock. These shares carried nondetach¬
able warrants for one share of common stock at $30 a share for
each two shares of preferred stock held. The subscription

1 This danger was avoided in the case of Atchison, Topeka and Santa Fe
Railway Convertible 4^3, due 1948, by permitting the issue to be called
only after the conversion privilege expired in 193S. (On the other hand,
Affiliated Fund Secured Convertible Debentures are callable at par at any
time on 30 days' notice, in effect allowing the company to destroy any
chance of profiting from the conversion privilege.)

Another protective device recently employed is to give the holder of a
convertible issue a stock-purchase warrant, at the time the issue is redeemed,
entitling the holder to buy the number of shares of common stock that would
have been received upon conversion if the senior issue had not been
redeemed. See Freeport Texas Company 6% Cumulative Convertible
Proferrod, issued in January 1933. United Biscuit 7% Preferred, converti¬
ble into shares of common, is callable at 110; but if called before Dec. 31,
1935, the holder had the option to take $100 in cash, plus a warrant to buy
2)4 shares of common at 40 until Jan. 1, 1936.

306

SECURITY ANALYSIS

privilege was to run to November 1, 1938, and was protected by
a provision for the issuance of a detached warrant evidencing the
same privilege per share in case the preferred stock was redeemed
prior to November 1, 1938. Some of the preferred stock was
called for redemption on January 1, 1933, and detached warrants
were accordingly issued to the holders thereof. (A year later the
remainder of the issue was called and additional warrants issued.)

Third Advantage of Warrant-bearing Issues. —Subscription-
warrant issues have still a third advantage over other privileged
securities, and this is in a practical sense probably the most
important of all. Let us consider what courses of conduct are
open to holders of each type in the favorable event that the
company prospers, that a high dividend is paid on the common,
and that the common sells at a high price.

1. Holder of a participating issue:

a. May sell at a profit.

b. May hold and receive participating income.

2. Holder of a convertible issue:

а. May sell at a profit.

б. May hold but will receive no benefit from high common dividend.

c. May convert to secure larger income but sacrifices his senior position.

3. Holder of an issue with stock-purchase warrants:

a. May sell at a profit.

b. May hold* but will receive no benefit from high common dividend.

c. May subscribe to common to receive high dividend. He may invest
new capital, or he may sell or apply his security ex-warrants to provide
funds to pay for the common. In either case he undertakes the risks
of a common stockholder in order to receive the high dividend income.

d. May dispose of his warrants at a cash profit and retain his original
security, ex-warrants. (The warrant may be sold directly, or he may
subscribe to the stock and immediately sell it at the current indicated
profit.)

The fourth option listed above is peculiar to a subscription-
warrant issue and has no counterpart in convertible or participat¬
ing securities. It permits the holder to cash his profit from the
speculative component of the issue and still maintain his original
investment position. Since the typical buyer of a privileged
senior issue should be interested primarily in making a sound
investment—with a secondary opportunity to profit from the
privilege—this fourth optional course of conduct may prove a
great convenience. He is not under the necessity of selling the
entire commitment, as he would be if he owned a convertible,

SENIOR SECURITIES WITH SPECULATIVE FEATURES 307

which would then require him to find some new medium for the
funds involved. The reluctance to sell one good thing and buy
another, which characterizes the typical investor, is one of the
reasons that holders of high-priced convertibles are prone to
convert them rather than to dispose of them. In the case of
participating issues also, the owner can protect his principal profit
only by selling out and thus creating a reinvestment problem.

Example: The theoretical and practical advantage of subscrip¬
tion-warrant issues in this respect may be illustrated in the
case of Commercial Investment Trust Corporation 6^% Pre¬
ferred. This was issued in 1925 and carried warrants to buy
common stock at an initial price of $80 per share. In 1929 the
warrants sold as high as $69.50 per share of preferred. The
holder of this issue was therefore enabled to sell out its speculative
component at a high price and to retain his original preferred-
stock commitment, which maintained an investment status
throughout the depression until it was finally called for redemp¬
tion at 110 on April 1, 1933. At the time of the redemption
call the common stock was selling at the equivalent of about
$50 per old share. If the preferred stock had been convertible,
instead of carrying warrants, many of the holders would undoubt¬
edly have been led to convert and to retain the common shares.
Instead of netting a large profit they would have been faced with
a substantial loss.

Summary.—To summarize this section, it may be said that,
for long-pull holding, a sound participating issue represents the
best form of profit-sharing privilege. From the standpoint of
maximum price advance under favorable market conditions, a
senior issue with detachable stock-purchase warrants is likely
to show the best results. Furthermore, subscription-warrant
issues as a class have definite advantages in that the privilege
is ordinarily not subject to curtailment through early redemption
of the security, and they permit the realization of a speculative
profit while retaining the original investment position.

CHAPTER XXIV

TECHNICAL ASPECTS OF CONVERTIBLE ISSUES

The third division of the subject of privileged issues relates to
technical aspects of each type, separately considered. We shall
first discuss convertible issues.

The effective terms of a conversion privilege are frequently
subject to change during the life of the issue. These changes
are of two kinds: (1) a decrease in the conversion price, to protect
the holder against “dilution”; and (2) an increase in the conver¬
sion price (in accordance usually with a “sliding-scale” arrange¬
ment) for the benefit of the company.

Dilution, and Antidilution Clauses. —The value of a common
stock is said to be diluted if there is an increase in the number
of shares without a corresponding increase in assets and earning
power. Dilution may arise through split-ups, stock dividends,
offers of subscription rights at a low price, and issuance of stock
for property or services at a low valuation per share. The
standard “ antidilution ” provisions of a convertible issue endeavor
to reduce the conversion price proportionately to any decrease
in the per-share value arising through any act of dilution.

The method may be expressed in a formula, as follows: Let C
be the conversion price, 0 be the number of shares now out¬
standing, N be the number of new shares to be issued, and P be
the price at which they are to be issued.

Then

ru all . . N CO + NP

C (the new conversion price) = q -qp ^

The application of this formula to Chesapeake Corporation
Convertible Collateral 5s, due 1947, is given in Appendix Note
36, page 763. A simpler example of an antidilution adjustment is
afforded by the Central States Electric Corporation 6% Con¬
vertible Preferred previously referred to (page 302). After its

308

SENIOR SECURITIES WITH SPECULATIVE FEATURES 309

issuance in 1928, the common stock received successive stock
dividends of 100 and 200%. The conversion price was accord¬
ingly first cut in half (from $118 to $59 per share) and then again
reduced by two-thirds (to $19.66 per share).

A much less frequent provision merely reduces the conversion
price to any lower figure at which new shares may be issued. This
is, of course, more favorable to the holder of the convertible
issue. 1

Protection against Dilution Not Complete .—Although practically
all convertibles now have antidilution provisions, there have been
exceptions. 2 As a matter of course, a prospective buyer should
make certain that such protection exists for the issue he is
considering.

It should be borne in mind that the effect of these provisions
is to preserve only the principal or par value of the privileged
issue against dilution. If a convertible is selling considerably
above par, the premium will still be subject to impairment
through additional stock issues or a special dividend. A simple
illustration will make this clear.

A bond is convertible into stock, par for par. The usual
antidilution clauses are present. Both bond and stock are
selling at 200.

Stockholders are given the right to buy new stock, share for
share, at par ($100). These rights will be worth $50 per share,
and the new stock (or the old stock “ex-rights”) will be worth
150. No change will be made in the conversion basis, because
the new stock is not issued below the old conversion price.
However, the effect of offering these rights must be to compel
immediate conversion of the bonds, since otherwise they would
lose 25% of their value. As the stock will be worth only 150
“ex-rights,” instead of 200, the value of the unconverted bonds
would drop proportionately.

The foregoing discussion indicates that, when a large premium
or market profit is created for a privileged issue, the situation
is vulnerable to sudden change. Although prompt action will
always prevent loss through such changes, their effect is always

x See Appendix Note 37, p. 764, for example (Consolidated Textile
Corporation 7s, due 1923).

*See Appendix Note 38, p. 764, for example (American Telephone and
Telegraph Company Convertible 4Ks> due 1933).

310

SECURITY ANALYSIS

to terminate the effective life of the privilege. 1 The same
result will follow, of course, from the calling of a privileged
issue for redemption at a price below its then conversion
value.

Where the number of shares is reduced through recapitalization,
it is customary to increase the conversion price proportionately.
Such recapitalization measures include increases in par value,
“reverse split-ups” (e.g., issuance of 1 no-par share in place of,
say, 5 old shares), and eKchanges of the old stock for fewer new
shares through consolidation with another company. 2

Sliding Scales Designed to Accelerate Conversion.—The
provisions just discussed are intended to maintain equitably
the original basis of conversion in the event of subsequent
capitalization changes. On the other hand, a “sliding-scale”
arrangement is intended definitely to reduce the value of the
privilege as time goes on. The underlying purpose is to accelerate
conversion, in other words, to curtail the effective duration and
hence the real value of the option. Obviously, any diminution
of the worth of the privilege to its recipients must correspondingly
benefit the donors of the privilege, who are the company's
common shareholders.

The more usual terms of a sliding scale prescribe a series of
increases in the conversion price in successive periods of time.
A more recent variation makes the conversion price increase as
soon as a certain portion of the issue has been exchanged.

Examples: American Telephone and Telegraph Company Ten-
year Debenture 43^s, due 1939, issued in 1929, were made con¬
vertible into common at $180 per share during 1930, at $190 per
share during 1931 and 1932, and at $200 per share during 1933 to
1937, inclusive. These prices were later reduced through the
issuance of additional stock at $100, in accordance with the
standard antidilution provision.

1 To guard against this form of dilution, holders of convertible issues are
sometimes given the right to subscribe to any new offerings of common
stock on the same basis as if they owned the amount of common shares into
which their holdings are convertible. See the indentures securing New
York, New Haven and Hartford Railroad Company, Convertible Debenture
6s, due 1948, and Commercial Investment Trust Corporation Convertible
Debenture 5j^s, due 1949.

•See Appendix Note 39, p. 765, for example of Dodge Brothers, Inc.,
Convertible Debenture 6s, due 1940.

SENIOR SECURITIES WITH SPECULATIVE FEATURES 311

Anaconda Copper Mining Company Debenture 7s, due 1938,
were issued in the amount of $50,000,000. The first $10,000,000
presented were convertible into common stock at $53 per share;
the second $10,000,000 were convertible at $56; the third at
$59; the fourth at $62, and the final lot at $65. An $8,000,000
issue of Hiram Walker-Goderham and Worts 4)^s, due 1945, was
convertible as follows: at $40 per share for the first $2,000,000
block of bonds; at $45 per share for the next block of $2,000,000;
the third block at $55; and the final block at $60 per share.

Sliding Scale Based on Time Intervals .—The former type of
sliding scale, based on time intervals, is a readily understandable
method of reducing the liberality of a conversion privilege. Its
effect can be shown in the case of Porto Rican-American Tobacco
Company 6s, due 1942. These were convertible into pledged
Congress Cigar Company, Inc., stock at $80 per share prior to
January 2, 1929, at $85 during the next three years and at $90
thereafter. During 1928 the highest price reached by Congress
Cigar was 8734; which was only a moderate premium above the
conversion price. Nevertheless a number of holders were
induced to convert before the year-end, because of the impending
rise in the conversion basis. These conversions proved very
ill-advised, since the price of the common fell to 43 in 1929,
against a low of 89 for the bonds. In this instance, the adverse
change in the conversion basis not only meant a smaller potential
profit for those who delayed conversion until after 1928 but also
involved a risk of serious loss through inducing conversion at the
wrong time.

Sliding Scale Based on Extent Privilege Is Exercised .—The
second method, however, based on the quantities converted, is
not so simple in its implications. Since it gives the first lot
of bonds converted an advantage over the next, it evidently
provides a competitive stimulus to early conversion. By so doing
it creates a conflict in the minds of the holder between the desire
to retain his senior position and the fear of losing the more
favorable basis of conversion through prior action by other
bondholders. This fear of being forestalled will ordinarily
result in large-scale conversions as soon as the stock advances
moderately above the initial conversion price, t.c., as soon as the
bond is worth slightly more than the original cost. Accordingly,
the price of the senior issue should oscillate over a relatively

312

SECURITY ANALYSIS

narrow range while the common stock is advancing and whil#
successive blocks of bonds are being converted.

Example: The sequence of events normally to be expected is
shown fairly well by the market action of Hiram Walker-Goder-
ham and Worts Convertible 4J4s described on page 311. The
bonds, issued in 1936 at par, ranged in price between 100 and
11134 during 1936-1939. In the same period the stock ranged
between 2634 and 54. If the initial conversion price of 40 for
the stock had prevailed throughout the period, the bonds should
have sold for at least 135 when the stock sold at 54. But mean¬
while, as the price of the stock rose, successive blocks of the bonds
were converted (partly under the impetus supplied by successive
calls for redemption of parts of the issue), thus tipping off higher
conversion prices until the $55 bracket was reached in 1937. In
consequence the bonds did not appreciate commensurately with
the rise in the price of the stock. 1

When the last block under such a sliding scale is reached, the
competitive element disappears, and the bond or preferred stock
is then in the position of an ordinary convertible, free to advance
indefinitely with the stock.

It should be pointed out that issues with such a sliding-scale
provision do not always follow this theoretical behavior pattern.
The Anaconda Copper Company Convertible 7s, for example,
actually sold at a high premium (30%) in 1928, before the first
block was exhausted. This seems to have been one of the
anomalous incidents of the highly speculative atmosphere at the
time. 2 * * * * * From the standpoint of critical analysis, a convertible of
this type must be considered as having very limited possibilities
of enhancement until the common stock approaches the last and
highest conversion price. 8

1 See pp. 266-267 of the 1934 edition of this work for a more detailed
exhibit of a similar record in Engineers Public Service Company $5 Con¬
vertible Preferred in 1928-1929.

2 The size of the premium was due in part to the high coupon rate. The

bonds were, however, callable at 110, a point that the market ignored.

* In some cases ( e.g ., Porto Rican-American 6s, already mentioned, and

International Paper and Power Company First Preferred) the conversion

privilege ceases entirely after a certain fraction of the issue has been con¬
verted. This maintains the competitive factor throughout the life of the

privilege and in theory should prevent it from ever having any substantial

value.

SENIOR SECURITIES WITH SPECULATIVE FEATURES 313

The sliding-scale privilege on a “block” basis belongs to the
objectionable category of devices that tend to mislead the holder
of securities as to the real nature and value of what he owns.
The competitive pressure to take advantage of a limited oppor¬
tunity introduces an element of compulsion into the exercise of
the conversion right which is directly opposed to that freedom
of choice for a reasonable time which is the essential merit of such
a privilege. There seems no reason why investment bankers
should inject so confusing and contradictory a feature into a
security issue. Sound practice would dictate its complete
abandonment or in any event the avoidance of such issues by
intelligent investors.

Issues Convertible into Preferred Stock.—Many bond issues
were formerly made convertible into preferred stock. Ordinarily
some increase in income was offered to make the provision appear
attractive. (For examples, see Missouri-Kansas-Texas Railroad
Company Adjustment 5s, due 1967, convertible prior to January
1, 1932 into $7 preferred stock; Central States Electric Corpora¬
tion Debenture 5s, due 1948, convertible into $6 preferred stock;
G. It. Kinney Company Secured 7^s, due 1936, convertible into
$8 preferred stock; American Electric Power Corporation 6s, due
1957, convertible into $7 preferred stock.)

There have been instances in which a fair-sized profit has been
realized through such a conversion right, but the upper limitation
on the market value of the ordinary preferred stock is likely to
keep down the maximum benefits from such a privilege to a
modest figure. Moreover, since developments in recent years
have made preferred stocks in general appear far less desirable
than formerly, the right to convert, say, from a 4% bond into a
5% preferred is likely to constitute more of a danger to the
unwary than an inducement to the alert investor. If the
latter is looking for convertibles, he should canvass the market
thoroughly and endeavor to find a suitably secured issue con¬
vertible into common stock. In a few cases where bonds are
convertible into preferred stock, the latter is in turn convertible
into common or participates therewith, and this double arrange¬
ment may be equivalent to convertibility of the bond into com¬
mon stock. For example, International Hydro-Electric System
6s, due 1944, are convertible into Class A stock, which is in
reality a participating second preferred.

314

SECURITY ANALYSIS

There are also bond issues convertible into either preferred
or common or into a combination of certain amounts of each. 1
Although any individual issue of this sort may turn out well, in
general it may be said that complicated provisions of this sort
should be avoided (both by issuing companies and by security
buyers) because they tend to create confusion.

Bonds Convertible at the Option of the Company. —The
unending flood of variations in the terms of conversion and other
privileges that developed during the 1920s made it difficult
for the untrained investor to distinguish between the attractive,
the merely harmless, and the positively harmful. Hence he
proved an easy victim to unsound financing practices which in
former times might have stood out as questionable because of
their departure from the standard. As an example of this sort
we cite the various Associated Gas and Electric Company
“Convertible Obligations” which were made convertible by their
terms into preferred or Class A stock at the option of the company.
Such a contraption was nothing more than a preferred stock
masquerading as a bond. If the purchasers were entirely aware
of this fact and were willing to invest in the preferred stock, they
would presumably have no cause to complain. But it goes with¬
out saying that an artifice of this kind lends itself far too readily
to concealment and possible misrepresentation. 2

1 See, for example, the Chicago, Milwaukee, St. Paul and Pacific Railroad
Company Convertible Adjustment Mortgage 5s, Scries A, due Jan. 1, 2000,
which are convertible into 5 shares of the preferred and 5 shares of common.
For other examples see p. 623 in the Appendix of the 1934 edition of this
work.

‘These anomalous securities were variously entitled “investment certifi¬
cates,“convertible debenture certificates,” “interest-bearing allotment
certificates,” and “convertible obligations.” In 1932 the company com¬
pelled the conversion of the large majority of them, but the holder was given
an option (in addition to those already granted by the terms of the issues)
of converting into equally anomalous “Convertible Obligations, Series A
and B , due 2022,” which are likewise convertible into stock at the option
of the company. The company was deterred from compelling the conver¬
sion of some $17,000,000 “5H% Investment Certificates” after Nov. 15,
1933, by a provision in the indenture for that issue prohibiting the exercise
of the company's option in case dividends on the $5.50 Dividend Series
Preferred were in arrears (no dividends having been paid thereon since
June 15, 1932).

It is interesting to note that the Pennsylvania Securities Commission
prohibited the sale of these “Convertible Obligations” in December 1932

SENIOR SECURITIES WITH SPECULATIVE FEATURES 315

Bonds Convertible into Other Bonds,—Some bonds are con¬
vertible into other bonds. The usual case is that of a short-term
issue, the holder of which is given the right to exchange into a
long-term bond of the same Company. Frequently the long¬
term bond is deposited as collateral security for the note. (For
example, Interborough Rapid Transit Company 7s, due 1932,
were secured by deposit of $1,736 of the same company\s First
and Refunding 5s, due 1966, for each $1,000 note, and they were
also convertible into the deposited collateral, the final rate being
$1,000 of 5s for $900 of 7% notes.) The holder thus has an
option either to demand repayment at an early date or to make
a long-term commitment in the enterprise. In practice, this
amounts merely to the chance of a moderate profit at or before
maturity, in the event that the company prospers, or interest
rates fall, or both.

Unlike the case of a bond convertible into a preferred stock,
there is usually a reduction in the coupon rate when a short-term
note is converted into a long-term bond. The reason is that
short-term notes arc ordinarily issued when interest rates, either
in general or for the specific company, are regarded as abnormally
high, so that the company is unwilling to incur so steep a rate
for a long-term bond. It is thus expected that, when normal
conditions return, long-term bonds can be floated at a much
lower rate; and hence the right to exchange the note for a long¬
term bond, even on a basis involving some reduction in income,
may prove to be valuable. 1

because of their objectionable provisions. The company resisted the
Commission’s order in the Federal District Court of Philadelphia but later
dropped its suit (sec 135 Chronicle 4383, 4559; 136 Chronicle 326, 1011).

1 See the following issues taken from the 1920-1921 period: Shawinigan
Water and Power Company 7J^% Gold Notes, issued in 1920 and due in
1926, convertible into First and Refunding 6s, Series B , due 1950, which were
pledged as security; San Joaquin Light and Power Corporation Convertible
Collateral Trust 8s, issued in 1920 and due in 1935, convertible into the
pledged Series C First and Refunding 6s, due 1950; Great Western Power
Company of California Convertible Gold 8s, issued in 1920 and due in 1930,
convertible into pledged First and Refunding 7s, Series B , due in 1950.

Another type of bond-for-bond conversion is represented by Dawson
Railway and Coal 5s, due 1951, which are convertible into El Paso and
Southwestern Railroad Company First 5s,. due 1965 (the parent company,
which in turn is a subsidiary of the Southern Pacific). Such examples are
rare and do not invite generalization.

818 SECURITY ANALYSIS

Convertible Bonds with an Original Market Value in Excess
of Par. —One of the extraordinary developments of the 1928-1929
financial pyrotechnics was the offering of convertible issues with
an original market value greatly in excess of par. This is illus¬
trated by Atchison, Topeka and Santa Fe Railway Company
Convertible 4J^s, due 1948, and by American Telephone and
Telegraph Company Convertible 4^s, due 1939. Initial trading
in the former on the New York Curb Market (on a “when issued”
basis) in November 1928 was around 125, and initial trading in
the latter on the New York Stock Exchange (on a “when issued”
basis) on May 1, 1929, was at 142. Obviously investment in the
bonds at these levels represented primarily a commitment in the
common stock, since they were immediately subject to the danger
of a substantial loss of principal value if the stock declined.
Furthermore the income return was entirely too low to come
under our definition of investment. Although it may be thought
that the stockholders were acquiring a normal investment
through the exercise of their subscription right to purchase the
issues at par, the essential nature of their commitment was
determined by the initial market value of the security to which
they were subscribing. For this reason we think such financing
should be condemned, because under the guise of an attractive
investment it created a basically speculative form of security.

A Technical Feature of Some Convertible Issues.—A technical
feature of the American Telephone and Telegraph convertible
issue deserves mention. The bonds were made convertible at
180, but, instead of presenting $180 of bonds to obtain a share of
stock, the holder might present $100.of bonds and $80 in cash.
The effect of such an option is to make the bond more valuable
whenever the stock sells above 180 ( i.e ., whenever the conversion
value of the bond exceeds 100). This is illustrated as follows:

If the stock sells at 360, a straight conversion basis of 180
would make the bond worth 200. But by the provision accepting
$80 per share in cash, the value of the bond becomes 360 — 80 =
280.

This arrangement may be characterized as a combination of a
conversion privilege at 180 with a stock purchase right at 100.

Delayed Conversion Privilege. —The privilege of converting is
sometimes not operative immediately upon issuance of the
obligation.

SENIOR SECURITIES WITH SPECULATIVE FEATURES 317

Examples: This was true, for example, of Brooklyn Union Gas
Company Convertible 5^s, discussed in Note 38 of the Appendix.
Although they were issued in December 1925, the right to convert
did not accrue until January .1, 1929. Similarly, New York,
New Haven and Hartford Railroad Company Convertible
Debenture 6s, due in 1948, although issued in 1907, were not
convertible until January 15, 1923; Chesapeake Corporation
Convertible 5s, due 1947, were issued in 1927 but did not become
convertible until May 15, 1932.

More commonly the suspension of the conversion privilege
does not last so long as these examples indicate, but in any event
this practice introduces an additional factor of uncertainty and
tends to render the privilege less valuable than it would be
otherwise. This feature may account in part for the spread,
indicated in Note 38, page 764, of the Appendix, which existed
during 1926, 1927, and the early part of 1928 between the
Brooklyn Union Gas Company 5j^s and the related common
stock.

CHAPTER XXV

SENIOR SECURITIES WITH WARRANTS.
PARTICIPATING ISSUES. SWITCHING AND HEDGING

Nearly all the variations found in convertible issues have their
counterpart in the terms of subscription warrants. The purchase
price of the stock is ordinarily subject to change, up or down,
corresponding to the standard provisions for adjusting a conver¬
sion price.

Example: White Eagle Oil and Refining Company Debenture
5j^s, due 1937, were offered in March 1927 and carried warrants
entitling the holder to subscribe on or before March 15, 1932,
to 10 shares of the capital stock of the company at the following
prices:

$32 per share to and including March 15, 1928, and thereafter at

$34 per share to and including March 15, 1929, and thereafter at

$36 per share to and including March 15, 1930, and thereafter at

$38 per share to and including March 15, 1931, and thereafter at

$40 per share to and including March 15, 1932.

On January 27, 1930, the Standard Oil Company of New York
acquired the White Eagle properties by assuming the liabilities
of the latter company and exchanging 8% shares of Standard Oil
of New York for each 10 shares of White Eagle. In accordance
with the terms of the indenture protecting the warrants against
dilution and providing for readjustment of the subscription price
in the case of a sale of the properties or merger of the company,
the warrants thereafter entitled the holder to subscribe to 8%
shares of Standard Oil of New York (now Socony-Vacuum
Corporation) at $42.35 per share to and including March 15,1930,
at $44.71 for the next year and at $47.06 for the following year.

Sliding Scales of Both Types. —Sliding-scale arrangements of
both types are also encountered in option-warrant issues.

Examples: Interstate Department Stores, Inc., 7% Preferred,
issued in 1928, carried nondetachable warrants entitling the

318

SENIOR SECURITIES WITH SPECULATIVE FEATURES 310

holder to purchase common stock, share for share, at the follow¬
ing prices:

$37 per share up to January 31, 1929.

$42 per share up to January 31, 1931.

$47 per share up to January 31, 1933.

Central States Electric Corporation Optional 5%% Deben¬
tures, due 1954, carried detachable warrants entitling the holder
to buy, on or before September 15, 1934, 10 shares of common
stock for each $1,000 bond, at the following prices:

$89 per share for the first 25 % of the warrants exercised.

$94 per share for the next 25 % of the warrants exercised.

$99 per share for the next 25 % of the warrants exercised.

$104 per share for the last 25% of the warrants exercised.

As with convertibles, a sliding scale based on the “block”
principle detracts greatly from the value of the privilege until
the last block, i.e., the highest price, is reached, at which time it
becomes an ordinary purchase option.

Methods of Payment.—Stock-purchase warrants attached to
bonds or preferred stocks frequently provide that payment for
the common stock may be made either in cash or by turning in
the senior security itself at par. Such an arrangement may
prove directly equivalent to a conversion privilege. For example,
each share of American and Foreign Power Second Preferred was
issued with warrants to buy 4 shares of common at $25 per share.
Instead of paying cash, the holder can tender preferred stock
at a value of $100 per share. If he does so, he is actually convert¬
ing his preferred stock with warrants into common.

Similarly, the Rand Kardex h x /i % bonds, described in Chap.
XXII, could be tendered at par, in lieu of cash, upon exercising
the warrants. Since the warrants attached to a $1,000 bond
called for payment of $900 (22j^ shares at 40), the owner of a
$1,000 bond making payment in this fashion would have a $100
bond remaining. These provisions were thus equivalent to
convertibility of 90% of each bond into common.

More recent examples of this arrangement are Scullin Steel 6s
and warrants and Commercial Mackay Income 4s and warrants.

Advantage of Option to Pay Cash.—The option to pay cash
instead of turning in the senior issue must be considered an
advantage over a straight conversion privilege—first, because

820

SECURITY ANALYSIS

the bond or preferred, “ex-warrants,” may be worth more than
par, thus increasing the profit; second, because, as previously
explained, the holder may be glad to retain his investment
while realizing a cash profit on its speculative component; and
third, because the warrant is likely to sell separately at a greater
premium over its realizable value than a pure convertible.
All these advantages are illustrated by the Mohawk Hudson
Power Corporation Second Preferred with warrants as shown in
the table on page 302. This stock was tenderable at par, in
lieu of cash, upon exercise of the warrants, thus having rights
equivalent to convertibility, but the warrant arrangement
proved far more profitable than an equivalent conversion
privilege.

Detachability.—Stock-purchase warrants are either detachable,
nondetachable, or nondetachable for a certain period and
detachable thereafter. A detachable warrant may be exercised
upon presentation of the warrant alone. Hence it may be sold
separately from the issue of which it originally formed a part.
A nondetachable warrant or right may be exercised only in
conjunction with the senior issue; i.e., the bond or preferred stock
must be physically presented at the time of making payment
for the common shares. Hence such warrants may not be dealt
in separately. For example, the warrants attached to Monte-
catini 7s, due 1937, and those accompanying the Fiat Debenture
7s, due 1946, were detachable immediately after issuance.
Those attached to Loews, Inc., $6.50 Preferred, offered in Decem¬
ber 1927, were not detachable until July 1,1928; and the warrants
attached to the Loews, Inc., 6% Debentures, due 1941, were not
detachable until October 1, 1926, also six months after their
issuance. On the other hand, the warrants attached to Crown-
Zellerbach Corporation Debenture 6s, due 1940, and to Interstate
Department Stores, Inc., 7% Preferred were not detachable
during the life of the warrant, unless the senior issue to which
they were attached were called for redemption.

In an active stock market, separate option warrants are popular
with speculators (as pointed out before), and they sell at con¬
siderable premiums above their immediately realizable value.
Other things being equal, therefore, an issue with detachable
warrants will sell higher than one with a nonseparable right. In
view of this fact it may be asked why all subscription warrants

SENIOR SECURITIES WITH SPECULATIVE FEATURES 321

are not made immediately detachable, to give the holder the
benefit of their superior market appeal. The reason for making a
warrant nondetachable is that both the company and the under¬
writers of the issue wish to avoi'd the establishment of an unduly
low price for its bonds ex-warrants. Such a low price is likely
to follow if large purchases of the bond with warrants are made
by out-and-out speculators. For these holders, having no inter¬
est in the bond as such, are likely to detach the warrant and sell
the bond ex-warrants for whatever it will bring. Selling pressure
from this source, coupled with the absence of any steady demand
for the issue due to lack of “seasoning,” may result in so low a
price as to constitute an apparent reflection upon the corpora¬
tion's credit, which is evidently undesirable.

The compromise arrangement—which makes the warrant
detachable only after an interval—is based upon the assumption
that, after the security has had time to become fairly well known
in the investment world, a proper price may more readily be
established for the issue ex-warrants, even in the face of sales
by those who have profited from the warrants.

When once these subscription warrants were made detachable
from the related senior issue, they were bound to assume an
existence and characteristics of their own. From a mere append¬
age of bond financing they developed into an independent
form of security and a major vehicle of speculation during the
madness of 1928-1929. It is an amazing fact that the option
warrants created by one company, American and Foreign Power,
reached an indicated market value in 1929 of over a billion
dollars, a figure that exceeded the market value of all the railroad
common stocks of the United States listed on the New York Stock
Exchange in July 1932, less than three years later.

It will be necessary, therefore, to consider in a later chapter
the characteristics of stock-purchase warrants, viewed as an
independent speculative medium. At that time we shall discuss
the relationships between the prices of such warrants and of the
preferred and common shares of the same corporations.

PARTICIPATING ISSUES

Most of the traits of this type of privilege have already been
brought out in the preceding comparison with the other forms.
A distinction may be made between two kinds of participation.

322

SECURITY ANALYSIS

The more usual arrangement depends upon the dividend paid
upon the common; less frequently, the profit sharing is deter¬
mined by the earnings without reference to the dividend rate.

Examples: Westinghouse Electric and Manufacturing Company
Preferred, already described, is a standard example of the first
type; Budd Wheel Company Preferred illustrates the second.
In the latter case the basic dividend is 7 % cumulative, but this
rate increases to 8, 9, and 10%, according as the net earnings of
the previous year exceed $600,000; $800,000 and $1,000,000,
respectively. Celanese Corporation Participating First Pre¬
ferred and Celluloid Corporation Participating Second Preferred
are each entitled to a basic 7%, plus 10% of the earnings other¬
wise available for the common stock.

Preferred shares constitute the great bulk of participating
issues; participating bonds are rare and likely to deviate widely
in other respects from the standard bond pattern. The Kreuger
and Toll Participating Debentures, for example, although
nominally a bond, were in essence a nonvoting common stock.
The Green Bay and Western Railway (Participating) Debentures,
Series A and Series B, are in reality preferred and common stocks
respectively. Spanish River Pulp and Paper Mills, Ltd., First
6s, due 1931 but redeemed in 1928, are one of the few examples of
an investment-type bond with a participating privilege. 1 Sie¬
mens and Halske A. G. (a German enterprise) issued a series of
Participating Debentures, due 2930, carrying interest equal to
the rate of dividend paid upon the common stock but not less
than 6%.

Participating preferred stocks originally had a standard
pattern, exemplified by Westinghouse Electric and Manufactur¬
ing Company Preferred. The order of payment is first a fixed
preference to the senior shares, then a similar amount on the
common shares, and finally an equal participation, share for
share, in additional dividends. This pattern arose from the
common-law right of all classes of stock to share equally in
earnings and assets, except as otherwise provided by agreement.
Other examples of this arrangement are Chicago, Milwaukee,
St. Paul and Pacific Railroad Company Preferred; Wabash Rail¬
way Company 5% Preferred A; Consolidated Film Industries,
Inc., Preferred.

1 See Appendix Note 40, p. 766, for details concerning this issue.

SENIOR SECURITIES WITH SPECULATIVE FEATURES 323

In recent years, however, a wide diversity of participating
arrangements have made their appearance, so that there is now
no standard pattern. 1

Participating issues require two kinds of calculation: one
showing the number of times the fixed interest or dividend is
earned, and the other showing the amount per share or per bond
available for distribution under the participation privilege.

Example:

Celanese Corporation of America, 1938

Net for dividends. $2,479,749

Prior preferred dividend ($7). 1,153,726

First participating preferred dividend at $7

rate. 1,037,253

First participating preferred: additional par¬
ticipation . 28,877

Balance for common. 259,893

Prior preferred dividends earned. 2.15 times

Prior preferred and participating preferred

($7) dividends earned. 1.13 times

Earned for participating preferred: partici¬
pating basis. $7.19 per share

Privileged Issues Compared with the Related Common Stocks.

In our previous discussion of the merits of privileged issues as a
class it was pointed out that they sometimes offer a very attrac¬
tive combination of security and chance for profit. More
frequently, a decision may be reached that the privileged senior
security is preferable to the common stock of the enterprise.
Since a conclusion of this kind is based on comparative elements
only, it is likely to involve smaller risks of error than one that
asserts the absolute attractiveness of an issue.

Examples: Paramount Pictures Corporation $6 First Preferred
is convertible at any time into 7 shares of common. Towards
the end of 1936 it was selling at just about seven times the price
of the common, although it carried accumulated dividends of
nearly $12 per share, which of course would have to be paid before
the common could receive anything. ( E.g ., on October 17,1936,
the preferred sold at 113 against 15% for the common.)

Clearly a switch from the common into the preferred would
have been a wise move. The preferred stock could not be worth
1 For a number of variations of participating securities, see Appendix Note
3 in the 1934 edition of this work.

324

SECURITY ANALYSIS

less than seven times the price of the common; it might sell at
mom than this ratio, especially if the common declined in price;
it was certain to receive substantial dividends before anything
was disbursed on the common. The sequel promptly bore out
this analysis. In December 1936 back dividends of $12 per
share were paid on the preferred. In November 1937 the pre¬
ferred sold at 92}4, vs. only 10j4 for the common, showing a
spread of 20)4 points. Including $4.50 of additional dividends
paid on the preferred up to that time, the aggregate advantage
accruing to the preferred stock as against the common amounted
to fully $35 per share of preferred.

A virtually identical situation existed in Studcbaker Corpora¬
tion 3-6% Debentures, due 1945, and the common stock in 1936.
The bonds were convertible into 80 shares of common; they
carried 3% fixed interest and 3% cumulative contingent interest,
of which 5% % had accrued by November 18. Yet their price
was 12024, practically on a parity with the price of 15 for the com¬
mon. Less than a year later the bonds sold at 59)4 against only
3 for the common—a “spread,” or profit, on the exchange of
3524 points, exclusive of 3% fixed interest received on the bonds. 1

“Parity ” u Premium ” and “Discount .”—When the price of a
convertible bond or preferred is exactly equivalent, on an
exchange basis, to the current price of the common stock, the
two issues are said to be selling at a parity . 2 When the price of
the senior issue is above parity it is said to be selling at a premium ,
and the difference between its price and conversion parity is
called the amount of the premium, or the “spread.” Conversely
if the price of the convertible is below parity, the difference is
sometimes called the discount . 3

1 In the latter part of 1938 and 1939 a similar close relationship existed
between the price of Baldwin Locomotive Works 6s, due 1950, convertible
into 65 shares of common stock, and the price of the common. Compare the
highs of 17)4 for the stock and 116)4 for the bonds in 1938, with the respec¬
tive lows of 9J4 and 82)4 and the subsequent highs of 2134 and 139 in 1939.

*This should not be confused with par, which means simply the face
value of the security in question. “Par,” when applied to the price of a
common stock, nearly always means $100 per share and has no reference to
the real par value of the share, which may be quite different.

* If the senior issue may be promptly exchanged for the common, a dis¬
count results in creating an arbitrage opportunity. This is a chance to make
a profit (usually small) without risk of loss by: (1) simultaneously buying the
senior issue and selling the common stock; (2) immediately converting the

SENIOR SECURITIES WITH SPECULATIVE FEATURES 325

A Fruitful Field for Dependable Analysis .—The Paramount and
Studebaker examples give us that infrequent phenomenon —an
absolutely dependable conclusion arrived at by security analysis.
Holders of the common could not possibly lose by exchanging
into the convertible issues, and they had excellent prospects,
which in fact were realized, of deriving substantial benefits
in the form of both increased income and greater market value.
In this respect, privileged issues offer a fruitful field for the more
scientific application of the technique of analysis. The foregoing
examples are typical also of the price relationships created by an
active and advancing market. When there is a senior issue
convertible into common, the concentration of speculative
interest in the latter often results in establishing a price level
closely equivalent to (and sometimes even higher than) the price
of the senior issue, to which the public pays little attention.

Conclusion from Foregoing .—It is clear that a convertible issue
selling on a parity with the common is preferable thereto, except
when its price is so far above an investment level that it has
become merely a form of commitment in the common stock.
(Brooklyn Union Gas Company Convertible 5%s, due 1936, are
an example of the latter type of situation. The bonds, con¬
vertible into 20 shares of common from January 1, 1929, sold at
147 or higher during the years 1927-1932, inclusive, and sold at
489 in 1929.) It is generally worth while to pay some moderate
premium in order to obtain the superior safety of the senior issue.
This is certainly true when the convertible yields a higher income
return than the common, and it holds good to some extent even
if the income yield is lower.

Switching .—As a practical rule, therefore, holders of common
stocks who wish to retain their interest in the company should

senior issue into the common stock; and (3) delivering the common stock
against the sale, thus completing the transaction. Arbitraging of this
“open-and-shut” kind is done rather extensively in active, rising markets,
but the opportunities are usually monopolized by brokers specializing in
such operations. Other forms of intersecurity arbitrage operations arise
from reorganizations, mergers, stock split-ups, rights to buy new stocks, etc.
For detailed discussion see Meyer II. Weinstein, Arbitrage in Securities ,
Harper & Brothers, 1931. In the older sense, the term “arbitrage” applied
to simultaneous purchases and sales of the same security in different markets
(e.g., New York and London), and to similar operations involving foreign
exchange.

326

SECURITY ANALYSIS

always exchange into a convertible senior issue of the enterprise,
whenever it sells both at an investment level on its own account
and also close to parity on a conversion basis. Just how large a
premium a common stockholder should be willing to pay in
making such an exchange is a matter of individual judgment.
Because of his confidence in the future of his company, he is
usually unwilling to pay anything substantial for insurance
against a decline in value. But experience shows that he would
be wise to give up somewhat more than he thinks is necessary
in order to secure the strategic advantages that even a fairly
sound convertible issue possesses over a common stock. 1

Hedging. —These advantages of a strong convertible issue oyer
a common stock become manifest when the market declines.
The price of the senior issue will ordinarily suffer less severely
than the common, so that a good-sized spread may thereby be
established, instead of the near-parity previously existing. This
possibility suggests a special form of market operation, known
as “hedging,” in which the operator buys the convertible and
sells the common stock short against it, at an approximate
parity. 2 In the event of a protracted rise, he can convert the
senior issue and thus close out the transaction at only a slight
loss, consisting of the original spread plus carrying expenses.
But if the market declines substantially, he can “undo” the
operation at a considerable profit, by selling out the senior issue
and buying back the common.

1 The same reasoning holds true when both issues are confessedly
speculative.

Example: Western Maryland Railroad Preferred is convertible into
common share for share. It sold no higher than the common during tho
greater part of 1928-1933. Yet, if any one was willing to own the common,
he should have switched into the preferred, which had all the possibilities of
the common plus its senior position. Early in 1934 the preferred sold at a
fair premium above the common—23 against 17.

* “Hedging” in commodities is a superficially similar but basically differ¬
ent type of operation. Generally speaking, its purpose is to protect a
normal manufacturing or distributing profit against the chance of speculative
loss through commodity price changes. A miller, having bought wheat
that he will sell as flour some months later, will sell wheat futures as a
“ hedge” against the possibility of a decline in wheat destroying his profit
margin. When the flour is disposed of, he covers (buys back) the wheat
sold as protection. Most commodity hedging is thus designed as a safe¬
guard, whereas security hedging is usually intended to yield direct profits.

SENIOR SECURITIES WITH SPECULATIVE FEATURES 327

A practical illustration of a hedging operation is afforded by
Keith-Albee-Orpheum $7 Preferred, convertible at the time
into 3 shares of Radio-Keith-Orphcum A, the hedge being
established on March 1, 1929,' and the positions reversed or
“undone” on March 26, 1929, as follows:

1 . Sold (short) 300 R-K-O A @ 39 >3 on March

1, 1929. $11,962.50

Less commission ($45) and tax ($ 12 ). 57 00

Proceeds of short sale.$11,905.50

Bought 300 R-K-0 A @ 29 on March 26,

1929. $ 8,700.00

Plus commission on this purchase. 45 00

Cost of cover.$ 8,745 00

Profit on short sale. $3,160.50

2 . Bought on March 1 , 1929, 100 Keith-Albee-

Orpheum Pfd. @ 120 . $ 12,000 00

Plus commission ($25). 25 00

Cost of long stock. $12,025.00

Sold 100 Keith-Albce Orpheum Pfd. on

March 26, 1929 @98 . $ 9,800 00

Less commission ($ 20 ) and tax ($4). 24 00

Proceeds of long stock. $ 9,776 00

Plus dividend received on long stock. 175 00

(Preferred sold ex-div. on March 19,

1929) _

Net proceeds from sale of long stock and

dividends thereon. $ 9,951 00

Loss on long stock. $ 2,074.00

3. Profit on short sale. $ 3,160 50

Loss on long stock. 2,074 00

Net profit on hedge. $ 1,086.50

The profit indicated was about 9% on the capital tied up in
the transaction, and, since it covered a period of 26 days, the
profit was at the rate of over 100% per year. Since there was
no chance of loss on the transaction, a considerable part of the
cost of the preferred stock could properly have been borrowed,
thus largely increasing the percentage of profit on the capital
supplied by the operator. With favorable surrounding condi¬
tions, operations of this kind offer a chance for large gains against
a small maximum loss. They are particularly suitable as a form
of protection against other financial commitments, for they

328

SECURITY ANALYSIS

yield their profit in a declining market when other holdings ara
likely to show losses.

Some Technical Aspects of Hedging .—Hedging has numerous
technical aspects, however, which make it less simple and “fool¬
proof ” than our brief description would indicate. An exhaustive
discussion of hedging would fall outside the scope of this volume,
and for this reason we shall merely list below certain elements
that the experienced hedger will take into account in embarking
upon such operations:

1 . Ability to borrow stock sold and to maintain short position indefinitely. 1

2. Original cost of establishing position, including spread and commissions.

3. Cost of maintaining the position, including interest charges on long
holdings, dividends on short stock, possible premiums payable for borrowing
stock, and stamp taxes in connection with reborrowings of stock—less offsets
in the forms of dividends or interest receivable on long securities and possible
interest credit on short position.

4. Amount of profit at which operation will probably be closed out if
opportunity offers. Relationship between this maximum profit and
probable maximum loss, consisting of (2) plus (3).

It should be borne in mind in these, as in all other operations
in securities, that the potential profit to be taken into account is
not the maximum figure that might conceivably be reached
in the market but merely the highest figure for which the operator
is likely to wait before he closes out his position. Once a given
profit is taken, the additional profit that might have been
realized subsequently becomes of merely academic interest.

An Intermediate Form of Hedging .—An intermediate form of
hedging consists of purchasing a convertible issue and selling
only part of the related common shares, say, one-half of the
amount receivable upon conversion. On this basis a profit may
be realized in the event of either a substantial advance or a
substantial decline in the common stock. This is probably the
most scientific method of hedging, since it requires no opinion

1 Regulations of the S.E.C. and the stock exchanges have made short
selling more difficult since 1934. For example, short sales could be made
for a time only at a price higher than the last previous trade. The rule was
later relaxed to permit short sales at a price no lower than the last trade.
The obstacle imposed by these rules is mitigated in part by the fact that
hedges of the kind under discussion are ordinarily set up only in a rising
and fairly active market.

SENIOR SECURITIES WITH SPECULATIVE FEATURES 829

as to the future course of prices. An ideal situation of this kind
would meet the following two requirements:

1. A strongly entrenched senior issue that can be relied on to maintain
a price close to par even if the commori should drop precipitately. A good
convertible bond, maturing in a short time, is an ideal type for this purpose.

2. A common stock in which the speculative interest is large and that is
therefore subject to wide fluctuations in either direction.

An example of this form of hedge is supplied by operations
carried on in 1918-1919 in Pierce Oil 6s, due in 1920, and the
company’s common stock. 1

The advantages possessed by convertibles, along the lines just
described, are shared also by participating and purchase-warrant
issues. The latter types of privileged securities may, of course,
be used as media for hedging operations. Similarly, it may be
found most desirable to switch from common stocks into such
issues. The Rand Kardex 5j^s, described on page 288, were
not only an attractive direct commitment at the time of issuance,
but they were certainly a desirable substitute for the Class A
stock. Furthermore they offered an interesting hedging oppor¬
tunity. In like manner, persons committed to a permanent
investment in Wcstinghouse Electric and Manufacturing Com¬
pany would certainly have been wise to switch from the common
stock into the participating preferred when the latter sold at a
lower price than the common in 1929 or 1930. In this case,
however, a hedging operation between the preferred and common
would have involved special hazards, because the senior issue was
not convertible into the junior shares.

1 This operation is analyzed in the Appendix Note 41, p. 767.

CHAPTER XXVI

SENIOR SECURITIES OF QUESTIONABLE SAFETY

At the low point of the 1932 securities market the safety
of at least 80% of all corporate bonds and preferred stocks
was open to some appreciable degree of doubt. 1 Even prior to
the 1929 crash the number of speculative senior securities was
very large, and it must inevitably be still larger for some years
to come. The financial world is faced, therefore, with the
unpleasant fact that a considerable proportion of American
securities belong to what may be called a misfit category. A
low-grade bond or preferred stock constitutes a relatively
unpopular form of commitment. The investor must not buy
them, and the speculator generally prefers to devote his attention
to common stocks. There seems to be much logic to the view
that if one decides to speculate he should choose a thoroughly
speculative medium and not subject himself to the upper limita¬
tions of market value and income return, or to the possibility
of confusion between speculation and investment, which attach
to the lower priced bonds and preferred stocks.

Limitation of Profit on Low-priced Bonds Not a Real Draw¬
back. —But however impressive may be the objection to these
nondescript securities, the fact remains that they exist in enor¬
mous quantities, that they are owned by innumerable security
holders, and that hence they must be taken seriously into account
in any survey of security analysis. It is reasonable to conclude
that the large supply of such issues, coupled with the lack of a
natural demand for them, will make for a level of prices below
their intrinsic value. Even if an inherent unattractiveness in
the form of such securities be admitted, this may be more than
offset by the attractive price at which they may be purchased.
Furthermore, the limitations of principal profit in the case of a
low-priced bond, as compared with a common stock, may be of

1 See Appendix Note 42, p. 768, for data on bond prices in 1931-1934 and
1939.

330

SENIOR SECURITIES WITH SPECULATIVE FEATURES 331

only minor practical importance, because the profit actually
realized by the common-stock buyer is ordinarily no greater than
that obtainable from a speculative senior security. If, for
example, we are considering a 4% bond selling at 35, its maximum
possible price appreciation is about 70 points, or 200%. The
average common-stock purchase at 35 cannot be held for a greater
profit than this without a dangerous surrender to “ bull-market
psychology.’’

Two Viewpoints with respect to Speculative Bonds.—There
are two directly opposite angles from which a speculative bond
may be viewed. It may be considered in its relation to invest¬
ment standards and yields, in which case the leading question
is whether or not the low price and higher income return will com¬
pensate for the concession made in the safety factor. Or it may
be thought of in terms of a common-stock commitment, in which
event the contrary question arises; viz., “Does the smaller risk
of loss involved in this low-priced bond, as compared with a
common stock, compensate for the smaller possibilities of profit?”
The nearer a bond comes to meeting investment requirements—
and the closer it sells to an investment price—the more likely
are those interested to regard it from the investment view¬
point. The opposite approach is evidently suggested in the
case of a bond in default or selling at an extremely low price.
We are faced here with the familiar difficulty of classification
arising from the absence of definite lines of demarcation. Some
issues can always be found reflecting any conceivable status
in the gamut between complete worthlessness and absolute
safety.

Common-stock Approach Preferable .—We believe, however,
that the sounder and more fruitful approach to the field of
speculative senior securities lies from the direction of common
stocks. This will carry with it a more thorough appreciation of
the risk involved and therefore a greater insistence upon either
reasonable assurance of safety or especially attractive possi¬
bilities of profit or both. It induces also—among intelligent
security buyers at least—a more intensive examination of the
corporate picture than would ordinarily be made in viewing a
security from the investment angle.

Such an approach would be distinctly unfavorable to the
purchase of slightly substandard bonds selling at moderate dis-

332

SECURITY ANALYSIS

counts from par. These, together with high-coupon bonds of
second grade, belong in the category of “ business men's invest¬
ments^ which we considered and decided against in Chap. VII.
It may be objected that a general adoption of this attitude would
result in wide and sudden fluctuations in the price of many issues.
Assuming that a 4% bond deserves to sell at par as long as it
meets strict investment standards, then as soon as it falls slightly
below these standards its price would suffer a precipitous decline,
say, to 70; and, conversely, a slight improvement in its exhibit
would warrant its jumping suddenly back to par. Apparently
there would be no justification for intermediate quotations
between 70 and 100.

The real situation is not so simple as this, however. Differ¬
ences of opinion may properly exist in the minds of investors as to
whether or not a given issue is adequately secured, particularly
since the standards are qualitative and personal as well as
arithmetical and objective. The range between 70 and 100 may
therefore logically reflect a greater or lesser agreement concerning
the safety of the issue. This would mean that an investor would
be justified in buying such a bond, say, at 85, if his own considered
judgment regarded it as sound, although he would recognize
that there was doubt on this score in the minds of other investors
that would account for its appreciable discount from a prime
investment price. According to this view, the levels between
70 and 100, approximately, may be designated as the range of
“subjective variations” in the status of the issue.

The field of speculative values proper would therefore com¬
mence somewhere near the 70 level (for bonds with a coupon
rate of 4% or larger) and would offer maximum possibilities of
appreciation of at least 50% of the cost. (In the case of other
senior issues, 70% of normal value might be taken as the dividing
line.) In making such commitments, it is recommended that the
same general attitude be taken as in the careful purchase of a
common stock; in other words, that the income account and the
balance sheet be submitted to the same intensive analysis and
that the same effort be made to evaluate future possibilities—
favorable and unfavorable.

Important Distinctions between Common Stocks and Specula¬
tive Senior Issues. —We shall not seek, therefore, to set up stand¬
ards of selection for speculative senior issues in any sense

SENIOR SECURITIES WITH SPECULATIVE FEATURES 333

corresponding to the quantitative tests applicable to fixed-value
securities. On the other hand, although they should preferably
be considered in their relationship to the common-stock approach
and technique, it is necessary to appreciate certain rather impor¬
tant points of difference that exist between common stocks as a
class and speculative senior issues.

Low-priced Bonds Associated with Corporate Weakness .—The
limitation on the profit possibilities of senior securities has
already been referred to. Its significance varies with the indi¬
vidual case, but in general we do not consider it a controlling
disadvantage. A more emphatic objection is made against
low-priced bonds and preferred stocks on the ground that they
are associated with corporate weakness, retrogression, or depres¬
sion. Obviously the enterprise behind such a security is not
highly successful, and furthermore, it must have been following
a downward course, since the issue originally sold at a much
higher level. In 1928 and 1929 this consideration was enough
to condemn all such issues absolutely in the eyes of the general
public. Businesses were divided into two groups: those which
were successful and progressing, and those which were on the
downgrade or making no headway. The common shares of the
first group were desirable no matter how high the price; but no
security belonging to the second group was attractive, irrespective
of how low it sold.

This concept of permanently strong and permanently weak
corporations has been pretty well dissipated by the subsequent
depression, and we arc back to the older realization that time
brings unpredictable changes in the fortunes of business under¬
takings. 1 The fact that the low price of a bond or preferred stock
results from a decline in earnings need not signify that the com¬
pany's outlook is hopeless and that there is nothing ahead but
still poorer results. Many of the companies that fared very
badly in 1931-1933 regained a good part of their former earning
power, and their senior securities recovered from exceedingly low
prices to investment levels. It turned out, therefore, that there
was just as much reason to expect substantial recoveries in the

1 But see later references to The Ebb and Flow of Investment Value , by
Mead and Grodinski, published in 1939, which strongly espouses the thesis
stated in tho previous paragraph (infra, p. 367 and Appendix Note 71,

p. 828).

334

SECURITY ANALYSIS

quotations of depressed senior securities as in the price of com¬
mon stocks generally.

Many Undervalued in Relation to Their Status and Contractual
Position .—We have already mentioned that the unpopularity of
speculative senior securities tends to make them sell at lower
prices than common stocks, in relation to their intrinsic value.
From the standpoint of the intelligent buyer this must be con¬
sidered a point in their favor. With respect to their intrinsic
position, speculative bonds—and, to a lesser degree, preferred
stocks—derive important advantages from their contractual
rights. The fixed obligation to pay bond interest will usually
result in the continuation of such payments as long as they are
in any way possible. If we assume that a fairly large proportion
of a group of carefully selected low-priced bonds will escape
default, the income received on the group as a whole over a
period of time will undoubtedly far exceed the dividend return
on similarly priced common stocks.

Preferred shares occupy an immeasurably weaker position in
this regard, but even here the provisions transferring voting
control to the senior shares in the event of suspension of divi¬
dends will be found in some cases to impel their continuance.
Where the cash resources are ample, the desire to maintain an
unbroken record and to avoid accumulations will frequently
result in paying preferred dividends even though poor earnings
have depressed the market price.

Examples: Century Ribbon Mills, Inc., failed to earn its 7%
preferred dividend in eight out of the thirteen years from 1926 to
1938, inclusive, and the price repeatedly declined to about 50.
Yet the preferred dividend was continued without interruption
during this entire period, while the common received a total of
but 50 cents. Similarly, a purchaser of Universal Pictures Com¬
pany First Preferred at about 30 in 1929 would have received
the 8% dividend during three years of depression before the pay¬
ment was finally suspended.

Contrasting Importance of Contractual Terms in Speculation
and Investment .—The reader should appreciate the distinction
between the investment and the speculative qualities of preferred
stocks in this matter of dividend continuance. From the invest¬
ment standpoint, i.e ., the dependability of the dividend, the
absence of an enforceable claim is a disadvantage as compared

SENIOR SECURITIES WITH SPECULATIVE FEATURES 335

with bonds. From the speculative standpoint, t.e., the pos¬
sibility of dividends’ being continued under unfavorable con¬
ditions, preferred stocks have certain semicontractual claims to
consideration by the directors that undoubtedly give them an
advantage over common stocks.

Bearing of Working-capital and Sinking-fund Factors on
Safety of Speculative Senior Issues.—A large working capital,
which has been characteristic of even nonprosperous industrials
for some years past, is much more directly advantageous to the
senior securities than to the common stock. Not only does it
make possible the continuance of interest or preferred-dividend
payments, but it has an important bearing also on the retirement
of the principal, either at maturity or by sinking-fund operations
or by voluntary repurchase. Sinking-fund provisions, for bonds
as well as preferred stocks, contribute to the improvement of both
the market quotation and the intrinsic position of the issue. This
advantage is not found in the case of common stocks.

Examples: Francis H. Leggett Company, manufacturers and
wholesalers of food products, issued $2,000,000 of 7% preferred
stock carrying a sinking-fund provision which retired 3% of the
issue annually. By June 30, 1932, the amount outstanding had
been reduced to $608,500, and, because of the small balance
remaining, the issue was called for redemption at 110, in the
depth of the depression . Similarly, Century Ribbon Mills
Preferred was reduced from $2,000,000 to $544,000 between
1922 and 1938; and Lawrence Portland Cement Company
Debenture 5j^s were reduced from $2,000,000 to $650,000 on
December 31, 1938, the balance being called for redemption on
April 1, 1939.

Importance of Large Net-current-asset Coverage .—Where a low-
priced bond is covered several times over by net current assets, it
presents a special type of opportunity, because experience shows
that the chances of repayment are good, even though the earn¬
ings may be poor or irregular.

Examples: Electric Refrigeration Corporation (Kelvinator) 6s,
due 1936, sold at 66 in November 1929 when the net current assets
of the company according to its latest statement amounted
to $6,008,900 for the $2,528,500 of bonds outstanding. It
is true that the company had operated at a deficit in 1927 and
1928, but fixed charges were earned nearly nine times in the

336

SECURITY ANALYSIS

year ended September 30, 1929, and the net current assets wore
nearly four times the market value of the bond issue. The
bonds recovered to a price close to par in 1930 and were redeemed
at 105 in 1931. Similarly, Electric Refrigeration Building
Corporation First 6s, due 1936, which were in effect guaranteed
by Kelvinator Corporation under a lease, sold at 70 in July
1932 when the net current assets of the parent company amounted
to about six times the $1,073,000 of bonds outstanding and over
eight times the total market value of the issue. The bonds
were called at 1013^ in 1933.

Other examples that may be cited in this connection are
Murray Corporation First 63^>s, due 1934, which sold at 68 in
1932 (because of current operating deficits) although the com¬
pany had net current assets of over 2 x /i times the par value of
the issue and nearly four times their market value at that price;
Sidney Blumenthal and Company 7% Notes, due 1936, which
sold at 70 in 1926 when the company had net current assets of
twice the par value of the issue and nearly three times the total
market value thereof (they were called at 103 in 1930); Belding,
Heminway Company 6s, due 1936, which sold at 67 in 1930 when
the company had net current assets of nearly three times the par
value of the issue and over four times its market value. In the
latter case drastic liquidation of inventories occurred in 1930 and
1931, proceeds from which were used to retire about 80% of the
bond issue through purchases in the market. The balance of the
issue was called for payment at 101 early in 1934.

In the typical case of this kind the chance of profit will exceed
the chance of loss, and the probable amount of profit will exceed
the probable amount of loss. It may well be that the risk
involved in each individual case is still so considerable as to
preclude us from applying the term “ investment ” to such a com¬
mitment. Nevertheless, we suggest that if the insurance
principle of diversification of risk be followed by making a number
of such commitments at the same time, the net result should be
sufficiently dependable to warrant our calling the group purchase
an investment operation. This was one of the possibilities
envisaged in our broadened definition of investment as given in
Chap. IV.

Limitations upon Importance of Current-asset Position. —It is
clear that considerable weight attaches to the working-capital

SENIOR SECURITIES WITH SPECULATIVE FEATURES 337

exhibit in selecting speculative bonds. This importance must
not be exaggerated, however, to the point of assuming that,
whenever a bond is fully covered by net current assets, its safety
is thereby assured. The current, assets shown in any balance
sheet may be greatly reduced by subsequent operating losses;
more important still, the stated values frequently prove entirely
undependable in the event of insolvency. 1

Of the many examples of this point which can be given, we
shall mention R. Hoe and Company 7 % Notes and Ajax Rubber
Company First 8s. Although these obligations were covered
by net working capital in 1929, they subsequently sold as low as
2 cents on the dollar. (Sec also our discussion of Willys-Overland
Company First 6j<£s and Berkcy and Gay Furniture Company
First 6s in Note 34 of the Appendix. 2 )

Examples of Low-priced Industrial Bonds Covered by Net Current

Assets, 1932*

Name of issue

Due

Low

price

1932

Date of
balance
sheet

Net

current

assetsf

Funded
debt at

part

Normal interest
coverage

Period

Times

earned^

American Seating Cs.

1936

Sept. 1932

S 3,820

$ 3,056

1924-1930

5.2

Crucible Steel 5s.

McKesson & Robbins

1940

June 1932

16.1G3

13,250

1924-1930

9.4

5^9.

1950

Juno 1932

42,885

20,848

1925-1930

4.1

Marion Steam Shovel 6a..

1947

June 1932

4,598

2,417 (

1922-1930

3.9

National Acme 6s.

1942

Dec. 1931

4,327

1,963

1922-1930

5.5

* Sec appendix Note 43, p. 768, for c biief discussion of the sequel to these examples first
given m the 1934 edition of this woik

t 000 omitted.

X Coverage for 1931 charges, adjusted where necessary.

We must distinguish, therefore, between the mere fact that the
working capital, as reported, covers the funded debt and the more

1 The comparative reliability of the various components in the current-
assets figure (cash assets, receivables, inventories) will receive detailed
treatment in a discussion of balance-sheet analysis in Part VI.

* Perhaps it should be added that three of the four issues mentioned in
this paragraph had spectacular recoveries from the low prices of the depres¬
sion ( e.g., the new Hoe 7s, which were exchanged for the old 7s, sold at 100
in 1937).

338

SECURITY ANALYSIS

significant fact that it exceeds the bond issue many times over .
The former statement is always interesting, but by no means
conclusive. If added to other favorable factors, such as a good
earnings coverage in normal years and a generally satisfactory
qualitative showing, it might make the issue quite attractive but
preferably as part of a group-purchase in the field.

Speculative Preferred Stocks, Stages in Their Price History .—
Speculative preferred stocks are more subject than speculative
bonds to irrational activity, so that from time to time such
preferred shares are overvalued in the market in the same way
as common stocks. We thus have three possible stages in the
price history of a preferred issue, in each of which the market
quotation tends to be out of line with the value:

1. The first stage is that of original issuance, when investors are per¬
suaded to buy the offering at a full investment price not justified by its
intrinsic merit.

2. In the second stage the lack of investment merit has become manifest,
and the price drops to a speculative level. During this period the decline
is likely to be overdone, for reasons previously discussed.

3. A third stage sometimes appears in which the issue advances specu¬
latively in the same fashion as common stocks. On such occasions certain
factors of questionable importance—such as the amount of dividend
accumulations—are overemphasized.

An example of this third or irrational stage will be given
a little later.

The Rule of “ Maximum Valuation for Senior Issues .”—Both
as a safeguard against being led astray by the propaganda that
is characteristic of the third stage and also as a general guide in
dealing with speculative senior issues, the following principle of
security analysis is presented, which we shall call “the rule of
maximum valuation for senior issues.”

A senior issue cannot be worth , intrinsically , any more than a
common stock would be worth if it occupied the position of that
senior issue , with no junior securities outstanding.

This statement may be understood more readily by means
of an example.

Company X and Company Y have the same value. Company
X has 80,000 shares of preferred and 200,000 shares of common.
Company Y has only 80,000 shares of common and no preferred.
Then our principle states that a share of Company X preferred

SENIOR SECURITIES WITH SPECULATIVE FEATURES 339

cannot be worth more than a share of Company Y common.
This is true because Company Y common represents the same
value that lies behind both the preferred and common of Com¬
pany X .

Instead of comparing two equivalent companies such as X and
Yj we may assume that Company X is recapitalized so that the
old common is eliminated and the preferred becomes the sole
stock issue, i.e. f the new common stock. (To coin a term, we
may call such an assumed change the “ commonizing ” of a pre¬
ferred stock.) Then our principle merely states the obvious fact
that the value of such a hypothetical common stock cannot be
less than the value of the preferred stock it replaces, because
it is equivalent to the preferred plus the old common. The
same idea may be applied to a speculative bond, followed either
by common stock only or by both preferred and common. If
the bond is “commonized,” i.e. f if it is assumed to be turned
into a common stock, with the old stock issues eliminated, then
the value of the new common stock thus created cannot be less
than the present value of the bond.

This relationship must hold true regardless of how high the
coupon or dividend rate, the par value or the redemption price
of the senior issue may be and, particularly, regardless of what
amount of unpaid interest or dividends may have accumulated.
For if we had a preferred stock with accumulations of $1,000
per share, the value of the issue could be no greater than if it
were a common stock (without dividend accumulations) represent¬
ing complete ownership of the business. The unpaid dividends
cannot create any additional value for the company's securities
in the aggregate; they merely affect the division of the total value
between the preferred and the common.

Excessive Emphasis Placed on Amount of Accrued Dividends .—
Although a very small amount of analysis will show the above
statements to be almost self-evident truths, the public fails to
observe the simplest rules of logic when once it is in a gambling
mood. Hence preferred shares with large dividend accruals
have lent themselves readily to market manipulation in which the
accumulations are made the basis for a large advance in the price
of both the preferred and common. An excellent example of such
a performance was provided by American Zinc, Lead and Smelt¬
ing Company shares in 1928.

340

SECURITY ANALYSIS

American Zinc preferred stock was created in 1916 as a stock
dividend on the common, the transaction thus amounting to a
split-up of old common into preferred and new common. The
preferred was given a stated par of $25 but had all the attributes
of a $100-par stock ($6 cumulative dividends, redemption and
liquidating value of $100). This arrangement was evidently a
device to permit carrying the preferred issue in the balance sheet
as a much smaller liability than it actually represented. Between
1920 and 1927 the company reported continuous deficits (except
for a negligible profit in 1922); preferred dividends were suspended
in 1921, and by 1928 about $40 per share had accumulated.

In 1928 the company benefited moderately from the prevailing
prosperity and barely earned $6 per share on the preferred.
However, the company's issues were subjected to manipulation
that advanced the price of the preferred from 35 in 1927 to
118 in 1928, while the common rose even more spectacularly
from 6 to 57. These advances were accompanied by rumors
of a plan to pay off the accumulated dividends—exactly how, not
being stated. Naturally enough, this development failed to
materialize. 1

The irrationality of the gambling spirit is well shown here
by the absurd acceptance of unpaid preferred dividends as a
source of value for both the 'preferred and the common. The
speculative argument in behalf of the common stock ran as
follows: “The accumulated preferred dividends are going to be
paid off. This will be good for the common. Therefore let
us buy the common." According to this topsy-turvy reason¬
ing, if there were no unpaid preferred dividends ahead of the
common it would be less attractive (even at the same price),
because there would then be in prospect no wonderful plan for
clearing up the accumulations.

We may use the American Zinc example to demonstrate the
practical application of our “rule of maximum valuation for
senior issues." Was American Zinc Preferred too high at 118
in 1928? Assuming the preferred stockholders owned the com¬
pany completely, this would then mean a price of 118 for a
common stock earning $6 per share in 1928 after eight years of

1 But years later, in 1936, accumulated preferred dividends were taken
care of by a recapitalization plan which gave the preferred stockholders the
bulk of the enlarged common issue.

SENIOR SECURITIES WITH SPECULATIVE FEATURES 341

deficits. Even in the hectic days of 1928 speculators would not
have been at all attracted to such a common stock at that price,
so that the application of our role should have prevented the
purchase of the preferred stock at its inflated value.

The quotation of 57 reached by American Zinc common was
evidently the height of absurdity, since it represented the
following valuation for the company:

Preferred stock, 80,000 sh. @118. $ 9,440,000

Common stock, 200,000 sh. @ 57. 11,400,000

Total valuation. $20,840,000

Earnings, 1928. 481,000

Average earnings, 1920-1927. 188,000{d)

In order to equal the above valuation for the American Zinc
Company the hypothetical common stock (80,000 shares basis)
would have had to sell at $260 per share , earning a bare $6 and
paying no dividend. This figmc indicates the extent to which
the heedless public was led astray in this case by the exploitation
of unpaid dividends.

American Hide and Leather Company offers another, but less
striking, example of this point. In no year between 1922 and
1928, inclusive, did the company earn more than $4.41 on the
preferred, and the average profits were very small. Yet in each
of these seven years, the preferred stock sold as high as 66 or
higher. This recurring strength was based largely on the specu¬
lative appeal of the enormous accumulated preferred dividends
which grew from about $120 to $175 per share during this period.

Applying our rule, we may consider American Hide and Leather
Preferred as representing complete ownership of the business,
which to all intents and purposes it did. We should then have
a common stock which had paid no dividends for many years and
with average earnings at best (using the 1922-1927 period) of
barely $2 per share. Evidently a price of above 65 for such a
common stock would be far too high. Consequently this price
was excessive for American Hide and Leather Preferred, nor
could the existence of accumulated dividends, however large,
affect this conclusion in the slightest.

Variation in Capital Structure Affects Total Market Value of
Securities.—From the foregoing discussion it might be inferred
that the value of a single capital-stock issue must always be
equivalent to the combined values of any preferred and common-

342

SECURITY ANALYSIS

stock issues into which it might be split. In a theoretical sense
this is entirely true, but in practice it may not be true at all,
because a division of capitalization into senior securities and
common stock may have a real advantage over a single common-
stock issue. This subject will receive extended treatment under
the heading of “Capitalization Structure” in Chap. XL.

The distinction between the idea just suggested and our “rule
of maximum valuation” may be clarified as follows:

1. Assume Company X — Company Y

2. Company X has preferred (P) and common (C); Company F has
common only ( C')

3. Then it would appear that

Value of P + value of C = value of C'

since each side of the equation represents equal things, namely the total
value of each company.

But this apparent relationship may not hold good in practice
because the preferred-and-common capitalization method may
have real advantages over a single common-stock issue.

On the other hand, our “rule of maximum valuation” merely
states that the value of P alone cannot exceed value of C'. This
should hold true in practice as well as in theory, except in so far
as manipulative or heedlessly speculative activity brushes aside
all rational considerations.

Our rule is stated in negative form and is therefore essentially
negative in its application. It is most useful in detecting
instances where preferred stocks or bonds arc not worth their
market price. To apply it positively it would be necessary,
first, to arrive at a value for the preferred on a “commonizcd”
basis ( i.e ., representing complete ownership of the business) and
then to determine what deduction from this value should be
made to reflect the part of the ownership fairly ascribable to
the existing common stock. At times this approach will be
found useful in establishing the fact that a given senior issue is
worth more than its market price. But such a procedure brings
us far outside the range of mathematical formulas and into
the difficult and indefinite field of common-stock valuation, with
which we have next to deal.

PART IV

THEORY OF COMMON-STOCK INVESTMENT.
THE DIVIDEND FACTOR

CHAPTER XXVII

THE THEORY OF COMMON-STOCK INVESTMENT

In our introductory discussion wo set forth the difficulties
inherent in efforts to apply the analytical technique to speculative
situations. Since the speculative factors bulk particularly
large in common stocks, it follows that analysis of such issues
is likely to prove inconclusive and unsatisfactory; and even where
it appears to be conclusive, there is danger that it may be mis¬
leading. At this point it is necessary to consider the function
of common-stock analysis in greater detail. We must begin
with three realistic premises. The first is that common stocks
are of basic importance in our financial scheme and of fascinating
interest to many people; the second is that owners and buyers of
common stocks are generally anxious to arrive at an intelligent
idea of their value; the third is that, even when the underlying
motive of purchase is mere speculative greed, human nature
desires to conceal this unlovely impulse behind a screen of appar¬
ent logic and good sense. To adapt the aphorism of Voltaire, it
may be said that if there were no such thing as common-stock
analysis, it would be necessary to counterfeit it.

Broad Merits of Common-stock Analysis.—We are thus led
to the question: “To what extent is common-stock analysis a
valid and truly valuable exercise, and to what extent is it an
empty but indispensable ceremony attending the wagering of
money on the future of business and of the stock market?” We
shall ultimately find the answer to run somewhat as follows:
“As far as the typical common stock is concerned—an issue picked
at random from the list—an analysis, however elaborate, is

343

344

SECURITY ANALYSIS

unlikely to yield a dependable conclusion as to its attractiveness
or its real value. But in individual cases, the exhibit may be
such as to permit reasonably confident conclusions to be drawn
from the processes of analysis.” It would follow that analysis
is of positive or scientific value only in the case of the exceptional
common stock, and that for common stocks in general it must be
regarded either as a somewhat questionable aid to speculative
judgment or as a highly illusory method of aiming at values
that defy calculation and that must somehow be calculated none
the less.

Perhaps the most effective way of clarifying the subject is
through the historical approach. Such a survey will throw light
not only upon the changing status of common-stock analysis
but also upon a closely related subject of major importance,
viz., the theory of common-stock investment. We shall encoun¬
ter at first a set of old established and seemingly logical principles
for common-stock investment. Through the advent of new
conditions, we shall find the validity of these principles impaired.
Their insufficiency will give rise to an entirely different con¬
cept of common-stock selection, the so-called “new-era theory,”
which beneath its superficial plausibility will hold possibilities
of untold mischief in store. With the prewar theory obsolete
and the new-era theory exploded, we must finally make the
attempt to establish a new set of logically sound and reasonably
dependable principles of common-stock investment.

History of Common-stock Analysis.—Turning first to the
history of common-stock analysis f we shall find that two con¬
flicting factors have been at work during the past 30 years. On
the one hand there has been an increase in the investment prestige
of common stocks as a class, due chiefly to the enlarged number
that have shown substantial earnings, continued dividends,
and a strong financial condition. Accompanying this progress
was a considerable advance in the frequency and adequacy of
corporate statements, thus supplying the public and the securities
analyst with a wealth of statistical data. Finally, an impres¬
sive theory was constructed asserting the preeminence of common
stocks as long-term investments. But at the time that the
interest in common stocks reached its height, in the period
between 1927 and 1929, the basis of valuation employed by the
stock-buying public departed more and more from the factual

THEORY OF COMMON-STOCK INVESTMENT 345

approach and technique of security analysis and concerned
itself increasingly with the elements of potentiality and prophecy.
Moreover, the heightened instability in the affairs of industrial
companies and groups of enterprises, which has undermined
the investment quality of bonds in general, has of course been
still more hostile to the maintenance of true investment quality
in common stocks.

Analysis Vitiated by Two Types of Instability. —The extent to
which common-stock analysis has been vitiated by these two
developments, (1) the instability of tangibles and (2) the domi¬
nant importance of intangibles, may be better realized by a
contrast of specific common stocks prior to 1920 and in more
recent times. Let us consider four typical examples: Pennsyl-

PENNSYLVANIA RAILROAD COMPANY
Range for stock

70- 56
74-66
74—61

71- 52

68- 52

76- 63

69- 61
65-59

63- 60
62-53

48-41
50-42
55-43
57-49
68-57

77- 62
110-73

87-53

64- 16
23- 7
42-14
38-20
33-27
45-28
50-20
25-14

Earned per share

Paid per share

$4 63

S3.00

4 98

3.00

5.83

3.25

5.32

3.50

4.46

3.00

4.37

3.00

4.60

3.00

4.14

3.00

4.64

3 00

4.20

3.00

5.16

3.00

3.82

3 00

6.23

3.00

6.77

3 125

6 83

3.50

7.34

3.50

8.82

3.875

5.28

4 00

1.48

3.25

1.03

0.50

1.40

0.50

1.43

1.00

1.81

0.50

2 94

2.00

2.07

1.25

0.84

0.50

346

SECURITY ANALYSIS

vania Railroad, Atchison, Topeka and Santa Fe Railway,
National Biscuit and American Can.

Atchison, Topeka and Santa Fe Railway Company

Year

Range of stock

Earned per share

Paid per share

1904

89- 64

$ 9.47*

$ 4.00

1905

93- 78

5.92*

4.00

1906

111- 85

12.31*

4.50

1907

15.02*

6.00

1908

7.74*

5.00

1909

12.10*

5.50

1910

8.89*

6.00

1911

9.30* 1

$.00

1912

8.19*

6.00

1913

8.62*

6.00

1923

15.48

6 00

1924

15.47

6.00

1925

141-116

17 19

7.00

1926

172-122

23 42

7.00

1927

200-162

18.74

10.00

1928

204-183

18.09

10 00

1929

299-195

22.69

10 00

1930

243-168

12.86

10 00

1931

203- 79

6.96

10 00

1932

94- 18

0.55

2.50

1933

80- 35

1.03(d)

Nil

1934

74- 45

0.33

2.00

1935

60 - 36

1.38

2.00

1936

89- 59

1.56

2.00

1937

95- 33

0.60

2.00

1938

45- 22

0.83

Nil

* Fiscal years ended June 30.

American Can was a typical example of a prewar speculative
stock. It was speculative for three good and sufficient reasons:
(1) It paid no dividend; (2) its earnings were small and irregular;
(3) the issue was “watered,” t.e., a substantial part of its stated
value represented no actual investment in the business. By
contrast, Pennsylvania, Atchison and National Biscuit were
regarded as investment common stocks—also for three good
and sufficient reasons: (1) They showed a satisfactory record of
continued dividends; (2) the earnings were reasonably stable

THEORY OF COMMON-STOCK INVESTMENT

347

and averaged substantially in excess of the dividends paid; and
(3) each dollar of stock was backed by a dollar or more of actual
investment in the business.

National Biscuit Company

Year

Range for stock

Earned per share

Paid per share

1909

120-

$ 7.67*

$ 5.75

1910

120-

100

9.86*

6 00

1911

144-

117

1C 05*

8.75

1912

161-

114

9.59*

7.00

1913

130-

104

11.73*

7.00

1914

139-

120

9.52*

7.00

1915

132-

116

8 20*

7.00

1916

131-

118

9 72*

7.00

1917

123-

9.87f

7.00

1918

111-

11.63

7.00

(old basis) t '

(old basis) t

(old basis) %

1923

370-

266

$35.42

$21 00

1924

541-

352

38 15

28 00

1925

553-

455

40 53

28 00

1926

714-

518

44 24

35.00

1927

1,309-

663

49.77

42 00

1928

1,367-

1,117

51.17

49 00

1929

1,657-

980

57 40

52 50

1930

1,628-:

1,148

59.68

56 00

1931

1,466-

637

50 05

49 00

1932

820-

354

42 70

49 00

1933

1,061-

569

36 93

49 00

1934

S66-

453

27.48 '

42.00

1935

637-

389

22.93

31.50

1936

678-

503

30.28

35.00

1937

581-

298

28 35

28 00

1938

490-

271

30.80

28.00

* Earnings for the year ended Jan. 31 of the following year,
t Eleven months ending Dec. 31, 1917.

X Stock was split 4 for 1 in 1922, followed by a 75 % stock dividend. In 1930 it was again
split 2H for 1. Published figures applicable to new stock were one-seventh of those given
above for 1923-1929. Likewise the foregoing figures for 1930-1938 are 17H timos the pub¬
lished figures for those years.

If we study the range of market price of these issues during the
decade preceding the World War (or the 1909—1918 period for
National Biscuit), we note that American Can fluctuated widely
from year to year in the fashion regularly associated with specula-

348

SECURITY ANALYSIS

tive media but that Pennsylvania, Atchison and National
Biscuit showed much narrower variations and evidently tended
to oscillate about a base price ( i.e ., 97 for Atchison, 64 for
Pennsylvania and 120 for National Biscuit) that seemed to
represent a well-defined view of their investment or intrinsic
value.

American Can Company

Year

Range for stock

Earned per share

Paid per share

1904

$ 0.51*

1905

1906

1.30(d) t

1907

0.67(d)

1908

10- 4

0.44(d)

1909

15- 8

0.82(d)

1910

14- 7

0.15(d)

1911

13- 9

0.07

1912

47- 11

8.86

1913

47- 21

5.21

1923

108- 74

19.64

$ 5.00

1924

164- 96

20.51

6.00

1925

297-158

32 75

7.00

(old basis) §

(old basis) 5

1926

379-233

26.34

13.25

1927

466-262

24.66

12.00

1928

705-423

41.16

12.00

1929

1,107-516

48.12

30.00

1930

940-628

48.48

30.00

1931

779-349

30 66 i

30.00

1932

443-178

19.56

24.00

1933

603-297

30.24

24.00

1934

689-542

50.32

24.00

1935

898-660

34.98

30.00

1936

825-660

34.80

36.00

1937

726-414

36.48

24.00

1938

631-425

26.10

24.00

* Fiscal year ended Mar. 31, 1905.
t Nine months ended Dec. 31, 1905.

X Excluding fire losses of 58 cents a share.

$ Stock was split 6 for 1 in 1926. Published figures applicable to new stock were one-
sixth of those given for 1926-1938.

Prewar Conception of Investment in Common Stocks.—Hence
the prewar relationship between analysis and investment on the

THEORY OF COMMON-STOCK INVESTMENT

349

one hand and price changes and speculation on the other may be
set forth as follows: Investment in common stocks was confined
to those showing stable dividends and fairly stable earnings;
and such issues in turn were expected to maintain a fairly stable
market level. The function of analysis was primarily to search
for elements of weakness in the picture. If the earnings were
not properly stated; if the balance sheet revealed a poor current
position, or the funded debt was growing too rapidly; if the
physical plant was not properly maintained; if dangerous new
competition was threatening, or if the company was losing ground
in the industry; if the management was deteriorating or was
likely to change for the worse; if there was reason to fear for the
future of the industry as a whole—any of these defects or some
other one might be sufficient to condemn the issue from the
standpoint of the cautious investor.

On the positive side, analysis was concerned with finding those
issues which met all the requirements of investment and in
addition offered the best chance for future enhancement. The
process was largely a matter of comparing similar issues in the
investment class, e.g., the group of dividend-paying Northwestern
railroads. Chief emphasis would be laid upon the relative show¬
ing for past years, in particular the average earnings in relation
to price and the stability and the trend of earnings. To a
lesser extent, the analyst sought to look into the future and to
select the industries or the individual companies that were
likely to show the most rapid growth.

Speculation Characterized by Emphasis on Future Prospects .—In
the prewar period it was the well-considered view that when
prime emphasis was laid upon what was expected of the future,
instead of what had been accomplished in the past, a speculative
attitude was thereby taken. Speculation, in its etymology,
meant looking forward; investment was allied to “vested inter¬
ests’^’—to property rights and values taking root in the past .
The future was uncertain, therefore speculative; the past was
known, therefore the source of safety. Let us consider a buyer of
American Can common in 1910. He may have bought it
believing that its price was going to advance or be “put up” or
that its earnings were going to increase or that it was soon going
to pay a dividend or possibly that it was destined to develop
into one of the country’s strongest industrials. From the prewar

350

SECURITY ANALYSIS

standpoint, although one of these reasons may have been more
intelligent or creditable than another, each of them constituted
a speculative motive for the purchase.

Technique of Investing in Common Stocks Resembled That for
Bonds. —Evidently there was a close similarity between the
technique of investing in common stocks and that of investing in
bonds. The common-stock investor, also, wanted a stable
business and one showing an adequate margin of earnings over
dividend requirements. Naturally he had to content himself
with a smaller margin of safety than he would demand of a bond,
a disadvantage that was offset by a larger income return (6%
was standard on a good common stock compared with 43^%
on a high-grade bond), by the chance of an increased dividend
if the business continued to prosper, and—generally of least
importance in his eyes—by the possibility of a profit. A
common-stock investor was likely to consider himself as in no
very different position from that of a purchaser of second-grade
bonds; essentially his venture amounted to sacrificing a certain
degree of safety in return for larger income. The Pennsylvania
and Atchison examples during the 1904r-1913 decade will supply
specific confirmation of the foregoing description.

Buying Common Stocks Viewed as Taking a Share in a Business.
Another useful approach to the attitude of the prewar common-
stock investor is from the standpoint of taking an interest in a
private business. The typical common-stock investor was a
business man, and it seemed sensible to him to value any corpo¬
rate enterprise in much the same manner as he would value his
own business. This meant that he gave at least as much atten¬
tion to the asset values behind the shares as he did to their
earnings records. It is essential to bear in mind the fact that
a private business has always been valued primarily on the basis
of the “net worth” as shown by its statement. A man con¬
templating the purchase of a partnership or stock interest in a
private undertaking will always start with the value of that
interest as shown “on the books,” i.e., the balance sheet, and
will then consider whether or not the record and prospects are
good enough to make such a commitment attractive. An inter¬
est in a private business may of course be sold for more or less
than its proportionate asset value; but the book value is still
invariably the starting point of the calculation, and the deal is

THEORY OF COMMON-STOCK INVESTMENT

351

finally made and viewed in terms of the premium or discount from
book value involved.

Broadly speaking, the same attitude was formerly taken in an
investment purchase of a marketable common stock. The first
point of departure was the par value, presumably representing
the amount of cash or property originally paid into the business;
the second basal figure was the book value, representing the par
value plus a ratable interest in the accumulated surplus. Hence
in considering a common stock, investors asked themselves:
“Is this issue a desirable purchase at the premium above book
value, or the discount below book value, represented by the
market price?” “Watered stock” was repeatedly inveighed
against as a deception practiced upon the stock-buying public,
who were misled by a fictitious statement of the asset values
existing behind the shares. Hence one of the protective functions
of security anatysis was to discover whether or not the value of
the fixed assets, as stated on the balance sheet of a company,
fairly represented the actual cost or reasonable worth of the
properties.

Investment in Common Stocks Based on Threefold Concept .—We
thus sec that investment in common stocks was formerly based
upon the threefold concept of: (1) a suitable and established
dividend return, (2) a stable and adequate earnings record
and (3) a satisfactory backing of tangible assets. Each of these
three elements could be made the subject of careful analytical
study, viewing the issue both by itself and in comparison with
others of its class. Common-stock commitments motivated by
any other viewpoint were characterized as speculative, and it was
not expected that they should be justified by a serious analysis.

THE NEW-ERA THEORY

During the postwar period, and particularly during the latter
stage of the bull market culminating in 1929, the public acquired
a completely different attitude towards the investment merits
of common stocks. Two of the three elements above stated lost
nearly all their significance, and the third, the earnings record,
took on an entirely novel complexion. The new theory or
principle may be summed up in the sentence: “The value of a
common stock depends entirely upon what it will earn in the
future.”

352

SECURITY ANALYSIS J

From this dictum the following corollaries were drawn:

1. That the dividend rate should have slight bearing upon the value.

2. That since no relationship apparently existed between assets and
earning power, the asset value was entirely devoid of importance.

3. That past earnings were significant only to the extent that they indi¬
cated what changes in the earnings were likely to take place in the future.

This complete revolution in the philosophy of common-stock
investment took place virtually without realization by the stock¬
buying public and with only the most superficial recognition by
financial observers. An effort must be made to reach a thorough
comprehension of what this changed viewpoint really signifies.
To do so we must consider it from three angles: its causes, its
consequences and its logical validity.

Causes for This Changed Viewpoint.—Why did the investing
public turn its attention from dividends, from asset values, and
from average earnings to transfer it almost exclusively to the
earnings trend , i.e ., to the changes in earnings expected in the
future? The answer was, first, that the records of the past
were proving an undependable guide to investment; and, second,
that the rewards offered by the future had become irresistibly
alluring.

The new-era concepts had their root first of all in the obsoles¬
cence of the old-established standards. During the last genera¬
tion the tempo of economic change has been speeded up to such a
degree that the fact of being long established has ceased to be,
as once it was, a warranty of stability . Corporations enjoying
decade-long prosperity have been. precipitated into insolvency
within a few years. Other enterprises, which had been small
or unsuccessful or in doubtful repute, have just as quickly
acquired dominant size, impressive earnings, and the highest
rating. The major group upon which investment interest was
chiefly concentrated, viz., the railroads, failed signally to partici¬
pate in the expansion of national wealth and income and showed
repeated signs of definite retrogression. The street railways,
another important medium of investment prior to 1914, rapidly
lost the greater portion of their value as the result of the develop¬
ment of new transportation agencies. The electric and gas
companies followed an irregular course during this period, since
they were harmed rather than helped by the war and postwar
inflation, and their impressive growth was a relatively recent

THEORY OF COMMON-STOCK INVESTMENT

353

phenomenon. The history of industrial companies was a hodge¬
podge of violent changes, in which the benefits of prosperity
were so unequally and so impermanently distributed as to bring
about the most unexpected failures alongside of the most dazzling
successes.

In the face of all this instability it was inevitable that the
threefold basis of common-stock investment should prove
totally inadequate. Past earnings and dividends could no
longer be considered, in themselves, an index of future earnings
and dividends. Furthermore, these future earnings showed no
tendency whatever to be controlled by the amount of the actual
investment in the business—the asset values—but instead
depended entirely upon a favorable industrial position and upon
capable or fortunate managerial policies. In numerous cases
of receivership, the current assets dwindled, and the fixed assets
proved almost worthless. Because of this absence of any con¬
nection between both assets and earnings and between assets
and realizable values in bankruptcy, less and less attention
came to be paid cither by financial writers or by the general
public to the formerly important question of “net worth,” or
“book value”; and it may be said that by 1929 book value had
practically disappeared as an element in determining the attrac¬
tiveness of a security issue. It is a significant confirmation of
this point that “watered stock,” once so burning an issue, is now
a forgotten phrase.

Attention Shifted to the Trend of Earnings.—Thus the prewar
approach to investment, based upon past records and tangible
facts, became outworn and was discarded. Could anything be
put in its place? A new conception was given central importance
—that of trend of earnings . The past was important only in so
far as it showed the direction in which the future could be
expected to move. A continuous increase in profits proved that
the company was on the upgrade and promised still better results
in the future than had been accomplished to date. Conversely,
if the earnings had declined or even remained stationary during
a prosperous period, the future must be thought unpromising,
and the issue was certainly to be avoided

The Common-stocks-as-long-term-investments Doctrine.—
Along with this idea as to what constituted the basis for common-
stock selection emerged a companion theory that common

354

SECURITY ANALYSIS

stocks represented the most profitable and therefore the most
desirable media for long-term investment. This gospel was based
upon a certain amount of research, showing that diversified lists of
common stocks had regularly increased in value over stated
intervals of time for many years past. The figures indicated
that such diversified common-stock holdings yielded both a
higher income return and a greater principal profit than purchases
of standard bonds.

The combination of these two ideas supplied the “ investment
theory” upon which the 1927-1929 stock market proceeded.
Amplifying the principle stated on page 351, the theory ran as
follows:

1. “The value of a common stock depends on what it can earn in the
future.”

2. “Good common stocks are those which have shown a rising trend of
earnings.”

3. “Good common stocks will prove sound and profitable investmcnts/ ,

These statements sound innocent and plausible. Yet they
concealed two theoretical weaknesses that could and did result
in untold mischief. The first of these defects was that they
abolished the fundamental distinctions between investment
and speculation. The second was that they ignored the price
of a stock in determining whether or not it was a desirable
purchase.

New-era Investment Equivalent to Prewar Speculation.—A

moment’s thought will show that 11 new-era investment,” as
practiced by the public and the investment trusts, was almost
identical with speculation as popularly defined in preboom days.
Such “investment” meant buying common stocks instead of
bonds, emphasizing enhancement of principal instead of income,
and stressing the changes of the future instead of the facts of
the established past. It would not be inaccurate to state that
new-era investment was simply old-style speculation confined
to common stocks with a satisfactory trend of earnings. The
impressive new concept underlying the greatest stock-market
boom in history appears to be no more than a thinly disguised
version of the old cynical epigram: “Investment is successful
speculation.”

Stocks Regarded as Attractive Irrespective of Their Prices.—
The notion that the desirability of a common stock was entirely

THEORY OF COMMON-STOCK INVESTMENT

355

independent of its price seems incredibly absurd. Yet the new-
era theory led directly to this thesis. If a public-utility stock
was selling at 35 times its maximum recorded earnings, instead
of 10 times its average earnings, which was the preboom standard,
the conclusion to be drawn was not that the stock was now
too high but merely that the standard of value had been raised.
Instead of judging the market price by established standards
of value, the new era based its standards of value upon the
market price. Hence all upper limits disappeared, not only
upon the price at which a stock could sell but even upon the price
at which it would deserve to sell. This fantastic reasoning
actually led to the purchase at Si00 per share of common
stocks earning $2.50 per share. The identical reasoning would
support the purchase of these same shares at $200, at $1,000,
or at any conceivable price.

An alluring corollary of this principle was that making money
in the stock market was now the easiest thing in the world. It
was only necessary to buy “good” stocks, regardless of price,
and then to let nature take her upward course. The results of
such a doctrine could not fail to be tragic. Countless people
asked themselves, “ Why work for a living when a fortune can be
made in Wall Street without working?” The ensuing migration
from business into the financial district resembled the famous
gold rush to the Klondike, except that gold was brought to Wall
Street instead of taken from it.

Investment Trusts Adopted This New Doctrine.—An ironical
sidelight is thrown on this 1928-1929 theory by the practice of
the investment trusts. These were formed for the purpose of
giving the untrained public the benefit of expert administration
of its funds—a plausible idea and one that had been working
reasonably well in England. The earliest American investment
trusts laid considerable emphasis upon certain time-tried princi¬
ples of successful investment, which they were much better
qualified to follow than the typical individual. The most impor¬
tant of these principles were:

1. To buy in times of depression and low prices and to sell out in times of
prosperity and high prices.

2. To diversify holdings in many fields and probably in many countries.

3. To discover and acquire undervalued individual securities as the result
of comprehensive and expert statistical investigations.

356

SECURITY ANALYSIS

The rapidity and completeness with which these traditional
principles disappeared from investment-trust technique is one
of the many marvels of the period. The idea of buying in times
of depression was obviously inapplicable. It suffered from the
fatal weakness that investment trusts could be organized only
in good times, so that they were virtually compelled to make
their initial commitments in bull markets. The idea of world¬
wide geographical distribution had never exerted a powerful
appeal upon the provincially minded Americans (who possibly
were right in this respect), and with things going so much better
here than abroad this principle was dropped by common consent.

Analysis Abandoned by Investment Trusts .—But most para¬
doxical was the early abandonment of research and analysis in
guiding investment-trust policies. However, since these financial
institutions owed their existence to the new-era philosophy, it
was natural and perhaps only just that they should adhere closely
to it. Under its canons investment had now become so beauti¬
fully simple that research was unnecessary and elaborate statisti¬
cal data a mere incumbrance. The investment process consisted
merely of finding prominent companies with a rising trend of
earnings and then buying their shares regardless of price. Hence
the sound policy was to buy only what every one else was buying
—a select list of highly popular and exceedingly expensive issues,
appropriately known as the “blue chips. ,, The original idea of
searching for the undervalued and neglected issues dropped
completely out of sight. Investment trusts actually boasted
that their portfolios consisted exclusively of the active and stand¬
ard (i.e., the most popular and highest priced) common stocks.
With but slight exaggeration, it might be asserted that under
this convenient technique of investment, the affairs of a ten-
million-dollar investment trust could be administered by the
intelligence, the training and the actual labors of a single thirty-
dollar-a-week clerk.

The man in the street, having been urged to entrust his funds
to the superior skill of investment experts—for substantial
compensation—was soon reassuringly told that the trusts would
be careful to buy nothing except what the man in the street was
buying himself.

The Justification Offered. —Irrationality could go no further;
yet it is important to note that mass speculation can flourish

THEORY OF COMMON-STOCK INVESTMENT

357

only in such an atmosphere of illogic and unreality. The self-
deception of the mass speculator must, however, have its element
of justification. This is usually some generalized statement,
sound enough within its proper field, but twisted to fit the specula¬
tive mania. In real estate booms, the “reasoning” is usually
based upon the inherent permanence and growth of land values.
In the new-era bull market, the “rational” basis was the record
of long-term improvement shown by diversified common-stock
holdings.

A Sound Premise Used to Support an Unsound Conclusion.—

There was, however, a radical fallacy involved in the new-era
application of this historical fact. This should be apparent
from even a superficial examination of the data contained in the
small and rather sketchy volume from which the new-era theory
may be said to have sprung. The book is entitled Common
Stocks as Long-term Invest?ncnts ) by Edgar Lawrence Smith,
published in 1924. 1 Common stocks were shown to have a
tendency to increase in value with the years, for the simple
reason that they earned more than they paid out in dividends
and thus the reinvested earnings added to their worth. In a
representative case, the company would earn an average of 9%,
pay 6% in dividends, and add 3% to surplus. With good
management and reasonable luck the fair value of the stock
would increase with its book value, at the annual rate of 3%
compounded. This was, of course, a theoretical rather than a
standard pattern, but the numerous instances of results poorer
than “normal” might be offset by examples of more rapid growth.

The attractiveness of common stocks for the long pull thus lay
essentially in the fact that they earned more than the bond-
interest rate upon their cost. This would be true, typically, of a
stock earning $10 and selling at 100. But as soon as the price
was advanced to a much higher price in relation to earnings,
this advantage disappeared, and with it disappeared the entire
theoretical basis for investment purchases of common stocks . When

1 The reader is referred to Chelcie C. Bosland, The Common Stock Theory
of Investment , Its Development and Significance , New York, 1937, for a survey
of the literature on the common-stock theory. Common Stock Indexes by
Alfred Cowles 3d and associates, Bloomington, Ind., 1939, is a significant
work on this subject which has appeared since publication of Professor
Bosland’s book.

358

SECURITY ANALYSIS

in 1929 investors paid $200 per share for a stock earning $8, they
were buying an earning power no greater than the bond-interest
rate, without the extra protection afforded by a prior claim.
Hence in using the past performances of common stocks as the
reason for paying prices 20 to 40 times their earnings, the new-
era exponents were starting with a sound premise and twisting
it into a woefully unsound conclusion.

In fact their rush to take advantage of the inherent attractive¬
ness of common stocks itself produced conditions entirely different
from those which had given rise to this attractiveness and upon
which it basically depended, viz ., the fact that earnings had
averaged some 10% on market price. As we have seen, Edgar
Lawrence Smith plausibly explained the growth of common-stock
values as arising from the building up of asset values through
the reinvestment of surplus earnings. Paradoxically enough,
the new-era theory that exploited this finding refused to accord
the slightest importance to the asset values behind the stocks it
favored. Furthermore, the validity of Mr. Smith's conclusions
rested necessarily upon the assumption that common stocks
could be counted on to behave in the future about as they had
in the past. Yet the new-era theory threw out of account the
past earnings of corporations except in so far as they were
regarded as pointing to a trend for the future.

Examples Showing Emphasis on Trend of Earnings .—Take
three companies with the following exhibits:

Earnings per Share

Year

Company A
(Electric
Power & Light)

Company B
(Bangor &
Aroostook R.R.)

Company C
(Chicago
Yellow Cab)

1925

$1.01

$6.22

$5 52

192G

1.45

8.69

5.60

1927

2.09

8.41

4.54

1928

2.37

6.94

4.58

1929

2.98

8.30

4.47

5-year average.

$1.98

$7.71

$4.94

High price, 1929.

86^

90M

The 1929 high prices for these three companies show that the
new-era attitude was enthusiastically favorable to Company A ,

THEORY OF COMMON-STOCK INVESTMENT

359

unimpressed by Company B, and definitely hostile to Company
C. The market considered Company A shares worth more than
twice as much as Company C shares, although the latter earned
50% more per share than Company A in 1929 and its average
earnings were 150% greater. 1

Average vs. Trend of Earnings.— These relationships between
price and earnings in 1929 show definitely that the past exhibit
was no longer a measure of normal earning power but merely
a weathervane to show which way the winds of profit were
blowing. That the average earnings had ceased to be a depend¬
able measure of future earnings must indeed be admitted,
because of the greater instability of the typical business to which
we have previously alluded. But it did not follow at all that the
trend of earnings must therefore be a more dependable guide
than the average; and even if it were more dependable, it
would not necessarily provide a safe basis, entirely by itself, for
investment.

The accepted assumption that because earnings have moved
in a certain direction for some years past they will continue to
move in that direction is fundamentally no different from the
discarded assumption that because earnings averaged a certain
amount in the past they will continue to average about that
amount in the future. It may well be that the earnings trend
offers a more dependable clue to the future than does the earnings
average. But at best such an indication of future results is far
from certain, and, more important still, there is no method of
establishing a logical relationship between trend and price. 2
This means that the value placed upon a satisfactory trend must
be wholly arbitrary, and hence speculative, and hence inevitably
subject to exaggeration and later collapse.

Danger in Projecting Trends into the Future .—There are several
reasons why we cannot be sure that a trend of profits shown in

1 See Appendix Note 44, p. 7G9, for a discussion of the subsequent per¬
formance of these three companies.

* The new-era investment theory was conspicuously reticent on the mathe¬
matical side. The relationship between price and earnings, or price and
trend of earnings was anything that the market pleased to make it (note
the price of Electric Power and Light compared with its earnings record
given on p. 358). If an attempt were to be made to give a mathematical
expression to the underlying idea of valuation, it might bo said that it was
based on the derivative of the earnings, stated in terms of time. In recent

360

SECURITY ANALYSIS

the past will continue in the future. In the broad economic
sense, there is the law of diminishing returns and of increasing
competition which must finally flatten out any sharply upward
curve of growth. There is also the flow and ebb of the business
cycle, from which the particular danger arises that the earnings
curve will look most impressive on the very eve of a serious
setback. Considering the 1927-1929 period we observe that
since the trend-of-earnings theory was at bottom only a pretext
to excuse rank speculation under the guise of “investment,” the
profit-mad public was quite willing to accept the flimsiest evi¬
dence of the existence of a favorable trend. Rising earnings for a
period of five, or four, or even three years only, were regarded
as an assurance of uninterrupted future growth and a w r arrant
for projecting the curve of profits indefinitely upward.

Example: The prevalent heedlcssness on this score was most
evident in connection with the numerous common-stock fiol ations
during this period. The craze for a showing of rising profits
resulted in the promotion of many industrial enterprises that
had been favored by temporary good fortune and were just
approaching, or had already reached, the peak of their prosperity.
A typical example of this practice is found in the offering of
preferred and common stock of Schletter and Zander, Inc., a
manufacturer of hosiery (name changed later to Signature
Hosiery Company). The company was organized in 1929, to
succeed a company organized in 1922, and the financing was
effected by the sale of 44,810 shares of $3.50 convertible pre¬
ferred shares at $50 per share and 261,349 voting-trust certifi¬
cates for common stock at $26 pfer share. The offering circular
presented the following exhibit of earnings from the constituent
properties:

years more serious efforts have been made to establish a mathematical
basis for discounting expected future earnings or dividends. See Gabriel
Preinreich, The Theory of Dividends , New York, 1935; and J. B. Williams,
The Theory of Investment Value } Cambridge, Mass., 1938. The latter work
b built on the premise that the value of a common stock is equal to the
present value of all future dividends. This principle gives rise to an
elaborate series of mathematical equations designed to calculate exactly
what a common stock is worth, assuming certain vital facts about future
earnings, distribution policy and interest rates.

THEORY OF COMMON-STOCK INVESTMENT 361

Year

Net after federal
taxes

Per share of
preferred

Per share of

common

1925

$ 172,058

' $3.84

$0.06

1926

339,920

7 58

0.70

1927

563,856

12 5S

1.56

1928

1,021,308

22.79

3.31

The subsequent rccoid wa< as follows:

1929

I 1

1930

■HH

In 1931 liquidation of the company’s assets was begun, and a
total of $17 per sha j in liquidating dividends on the preferred
had been paid up to the enu o,' 1933. (Assets then remaining
for liquidation were negligible.) The common was wiped out.

This example illustrates one of the paradoxes of financial
history, viz., that at the very period when the increasing instabil¬
ity of individual companies had made the purchase of common
stocks far more precarious than before, the gospel of common
stocks as safe and satisfactory investments was preached to and
avidly accepted by the American public.

CHAPTER XXVIII

NEWER CANONS OF COMMON-STOCK
INVESTMENT

Our extended discussion of the theory of common-stock
investment has thus far led only to negative conclusions. The
older approach, centering upon the conception of a stable average
earning power, appears to have been vitiated by the increasing
instability of the typical business. As for the new-era view,
which turned upon the earnings trend as the sole criterion of
value, whatever truth may lurk in this generalization, its blind
adoption as a basis for common-stock purchases, without
calculation or restraint, was certain to end in an appalling debacle.
Is there anything at all left, then, of the idea of sound investment
in common stocks?

A careful review of the preceding criticism will show that it
need not be so destructive to the notion of investment in common
stocks as a first impression would suggest. The instability of
individual companies may conceivably be offset by means of
thoroughgoing diversification. Moreover, the trend of earnings,
although most dangerous as a sole basis for selection, may prove a
useful indication of investment merit. If this approach is a sound
one, there may be formulated an acceptable canon of common-
stock investment, containing the following elements:

1. Investment is conceived as a group operation, in which diversification
of risk is depended upon to yield a favorable average result.

2. The individual issues are selected by means of qualitative and quanti¬
tative tests corresponding to those employed in the choice of fixed-value
investments.

3. A greater effort is made, than in the case of bond selection, to determine
the future outlook of the issues considered.

Whether or not a policy of common-stock acquisition based
upon the foregoing principles deserves the title of investment is
undoubtedly open to debate. The importance of the question,
and the lack of well-defined and authoritative views thereon,

862

THEORY OF COMMON-STOCK INVESTMENT

363

compel ns to weigh here the leading arguments for and against
this proposition.

THREE GENERAL APPROACHES

Secular Expansion as Basis. —May the ownership of a carefully
selected, diversified group of common stocks, purchased at reason¬
able prices, be characterized as a sound investment policy? An
affirmative answer may be developed from any one of three
different kinds of assumptions relating to the future of American
business and the policy of selection that is followed. The first
will posit that certain basic and long-established elements in
this country's economic experience may still be counted upon.
These are (1) that our national wealth and earning power will
increase, (2) that such increase will reflect itself in the increased
resources and profits of our important corporations, and (3) that
such increases will in the main take place through the normal
process of investment of new capital and reinvestment of undis¬
tributed earnings. The third part of this assumption signifies
that a broad causal connection exists between accumulating
surplus and future earning power, so that common-stock selection
is not a matter purely of chance or guesswork but should be
governed by an analysis of past records in relation to current
market prices.

If these fundamental conditions still obtain, then common
stocks with suitable exhibits should on the whole present the
same favorable opportunities in the future as they have for
generations past. The cardinal defect of instability may not
be regarded, therefore, as menacing the long-range development
of common stocks as a whole. It does indeed exert a powerful
temporary effect upon all business through the variations of the
economic cycle, and it has permanently adverse effects upon
individual enterprises and single industries. But of these two
dangers, the latter may be offset in part by careful selection and
chiefly by wide diversification; the former may be guarded
against by unvarying insistence upon Ihe reasonableness of the
price paid for each purchase.

They would be rash authors who would express themselves
unequivocably for or against this basic assumption that American
business will develop in the future pretty much as in the past.
In our Introduction we point out that the experience of the last

364

SECURITY ANALYSIS

fifteen years weighs against this proposition. Without seeking
to prophesy the future, may it not suffice to declare that the
investor cannot safely rely upon a general growth of earnings to
provide both safety and profit over the long pull? In this
respect it would seem that we are back to the investor's attitude
in 1913—with the difference that his caution then seemed need¬
lessly blind to the powerful evidences of secular growth inherent
in our economy. Our caution today would appear, at least, to
be based on bitter experience and on the recognition of some
newer and less promising factors in the whole business picture.

Individual Growth as Basis of Selection.—Those who would
reject the suggestion that common-stock investment may be
founded securely on a general secular expansion may be attracted
to a second approach. This stresses the element of selectivity
and is based on the premise that certain favored companies may
be relied on to grow steadily. Hence such companies, when
located, can be bought with confidence as long-term investments.
This philosophy of investment is set forth at some length in the
1938 report of National Investors Corporation, an investment
trust, from which we quote as follows:

The studies by this organization, directed specifically toward improved
procedure in selection, afford evidence that the common stocks of growth
companies—that is, companies whose earnings move forward from cycle
to cycle, and are only temporarily interrupted by periodic business
depressions—offer the most effective medium of investment in the field
of common stocks, either in terms of dividend return or longer term
capital appreciation. We believe that this general conclusion can be
demonstrated statistically and is supported by economic analysis and
practical reasoning.

In considering this statement critically, we must start with the
emphatic but rather obvious assertion that the investor who can
successfully identify such “growth companies" when their shares
are available at reasonable prices is certain to do superlatively well
with his capital. Nor can it be denied that there have been
investors capable of making such selections with a high degree
of accuracy and that they have benefited hugely from their
foresight and good judgment. But the real question is whether
or not all careful and intelligent investors can follow this policy
with fair success.

THEORY OF COMMON-STOCK INVESTMENT

365

Three Aspects of the Problem .—Actually the problem falls into
three parts: First, what is meant by a “growth company”?
Second, can the investor identify such concerns with reasonable
accuracy? Third, to what extent does the price paid for such
stocks affect the success of the program?

1. What Are Growth Companies ?—The National Investors
Corporation discussion defined growth companies as those
“whose earnings move forward from eyrie to cycle.” How many
cycles are needed to meet this definition? The fact of the matter
seems to be that prior to 1930 a large proportion of all publicly
owned American businesses grew from cycle to cycle. The
distinguishing characteristic of growth companies, as now under¬
stood, developed only in the period between 1929 and 1936-1937.
In this one cycle we find that most companies failed to regain
their full depression losses. The minority that did so stand out
from the rest, and it is these which are now given the compli¬
mentary title of “growth companies.” But since this distinction
is in reality based on performance during a single cycle, how sure
can the investor be that it will be maintained over the longer
future?

It is true, from what we have previously said, that many of
the companies that expanded from 1929 to 1937 had participated
in the general record of growth prior to 1929, so that they combine
the advantages of a long period of upbuilding and an exceptional
ability to expand in the last decade. The following are examples
of large and well-known companies of this class:

Air Reduction.

Allis Chalmers.

Coca-Cola.

Commercial Credit.

Dow Chemical.

Du Pont.

International Business Machines.
International Nickel.
Libbey-Owcns-Ford.

Monsanto Chemical.
Owens-Illinois Glass.

J. C. Penney.

Procter and Gamble.
Sherwin-Williams Paint.
Standard Oil of New Jersey.
Scott Paper.

Union Carbide and Carbon.

2. Can the Investor Identify Them?— But our natural enthu¬
siasm for such excellent records is tempered somewhat by a sober¬
ing consideration. This is the fact that, viewed historically,
most successful companies of the past are found to have pursued
a well-defined life cycle, consisting first of a series of struggles

366

SECURITY ANALYSIS

and setbacks; second, of a halcyon period of prosperity and
persistent growth; which in turn passes over into a final
phase of supermaturity—characterized by a slackening of expan¬
sion and perhaps an actual loss of leadership or even profitability. 1
It follows that a business that has enjoyed a very long period
of increasing earnings may ipso facto be nearing its own “satura¬
tion point.” Hence the seeker for growth stocks really faces a
dilemma; for if he chooses newer companies with a short record
of expansion, he runs the risk of being deceived by a temporary
prosperity; and if he chooses enterprises that have advanced
through several business cycles, he may find this apparent
strength to be the harbinger of coming weakness.

We see, therefore, that the identification of a growth company
is not so simple a matter as it may at first appear. It cannot be
accomplished solely by an examination cf the statistics and
records but requires a considerable supplement of special investi¬
gation and of business judgment. Proponents of the growth-
company principle of investment are wont currently to lay great
emphasis on the element of industrial research. In the absence
of general business expansion, exceptional gains are likely to be
made by companies supplying new products or processes. These
in turn are likely to emerge from research laboratories. The
profits realized from cellophane, ethyl gas and various plastics,
and from advances in the arts of radio, photography, refrigera¬
tion, aeronautics, etc., have created a natural enthusiasm for
research as a business asset and a natural tendency to consider
the possession of research facilities as the sine qua non of indus¬
trial progress.

Still here, too, caution is needed. If the mere ownership of a
research laboratory could guarantee a successful future, every
company in the land would have one. Hence, the investor must
pay heed to the kind of facilities owned, the abilities of the
researchers and the potentialities of the field under investigation.
It is not impossible to study these points successfully, but the
task is not easy, and the chance of error is great.

3. Does the Price Discount Potential Growtht —The third source
of difficulty is perhaps the greatest. Assuming a fair degree of
confidence on the part of the investor that the company will

1 This characteristic pattern of successful enterprise is discussed at length
in the 1938 report of National Investors Corporation, pp. 4-6.

THEORY OF COMMON-STOCK INVESTMENT

367

expand in the future, what price is he justified in paying for this
attractive element? Obviously, if he can get a good future for
nothing , t.e., if the price reflects only the past record, he is making
a sound investment. But this is not the case, of course, if the
market itself is counting on future growth , Characteristically,
stocks thought to have good prospects sell at relatively high
prices. How can the investor tell whether or not the price is
too high? We think that there is no good answer to this question
—in fact we are inclined to think that even if one knew for a
certainty just what a company is fated to earn over a long period
of years, it would still be impossible to tell what is a fair price to
pay for it today. It follows that once the investor pays a sub¬
stantial amount for the growth factor , he is inevitably assuming
certain kinds of risk; viz,, that the growth will be less than he
anticipates, that over the long pull he will have paid too much
for what he gets, that for a considerable period the market will
value the stock less optimistically than he docs.

On the other hand, assume that the investor strives to avoid
paying a high premium for future prospects by choosing com¬
panies about which he is personally optimistic, although they are
not favorites of the stock market. No doubt this is the type of
judgment that, if sound, will prove most remunerative. But,
by the very nature of the case, it must represent the activity of
strong-minded and daring individuals rather than investment
in accordance with accepted rules and standards. 1

May Such Purchases Be Described as Investment Commit¬
ments? —This has been a longish discussion, because the subject
is important and not too well comprehended in Wall Street.
Our emphasis has been laid more on the pitfalls of investing for
future growth than on its advantages. But we repeat that this
method may be followed successfully if it is pursued with skill,
intelligence and diligent study. If so, is it appropriate to call
such purchases by the name of “investment”? Our answer is
“yes,” provided that two factors are present: the first, already
mentioned, that the elements affecting the future are examined
with real care and a wholesome scepticism, rather than accepted

1 The “ expanding-industry” criterion of common-stock investment is
vigorously championed in an arresting book The Ebb and Flow of Investment
Values , New York, 1939, by Edward S. Mead and J. Grodinsky. For a
consideration of their views in some detail see Appendix Note 71, p. 828.

368

SECURITY ANALYSIS

quickly via some easy generalization; the second, that the price
paid be not substantially different from what a prudent business
man would be willing to pay for a similar opportunity presented
tq him to invest in a private undertaking over which he could
exercise control.

We believe that the second criterion will supply a useful
touchstone to determine whether the buyer is making a well-
considered and legitimate commitment in an enterprise with an
attractive future, or instead, under the guise of “ investment,” he
is really taking a flier in a popular stock or else letting his private
enthusiasm run away with his judgment.

It will be argued, perhaps, that common-stock investments
such as we have been discussing may properly be made at a con¬
siderably higher price than would be justified in the case of a
private business, first, because of the great advantage of market¬
ability that attaches to listed stocks and, second, because the
large size and financial power of publicly owned companies make
them inherently more attractive than any private enterprise
could be. As to the second point, the price to be paid should
suitably reflect any advantages accruing by reason of size and
financial strength, but this criterion does not really depend on
whether the company is publicly or privately owned. On the
first point, there is room for some difference of opinion whether
or not the ability to control a private business affords a full
counterweight (in value analysis) to the advantage of market¬
ability enjoyed by a listed stock. To those who believe market¬
ability is more valuable than control, we might suggest that in
any event the premium to be paid for this advantage cannot
well be placed above, say, 20% of the value otherwise justified
without danger of introducing a definitely speculative element
into the picture.

Selection Based on Margin-of-safety Principle. —The third
approach to common-stock investment is based on the margin-
of-safety principle. If the analyst is convinced that a stock is
worth more than he pays for it, and if ho is reasonably optimistic
as to the company's future, he would regard the issue as a suitable
component of a group investment in common stocks. This
attack on the problem lends itself to two possible techniques.
One is to buy at times when the general market is low , measured
by quantitative standards of value. Presumably the purchases

THEORY OF COMMON-STOCK INVESTMENT 369

would then be confined to representative and fairly active issues.
The other technique would be employed to discover undervalued
individual common stocks, which presumably are available even
when the general market is not particularly low. In either case
the “margin of safety” resides in the discount at which the stock
is selling below its minimum intrinsic value, as measured by the
analyst. But with respect to the hazai ds and the psychological
factors involved, the two approaches differ considerably. Let
us discuss them in their order.

Factors Complicating Efforts to Exploit General Market Swings .—
A glance at the chart on page 6, showing the fluctuations of
common-stock prices since 1900, would suggest that prices are
recurrently too high and too low and that consequently there
should be repeated opportunities to buy stocks at less than their
value and to sell them out later at fair value or higher. A crude
method of doing this—but one apparently encouraged by the
chart itself—would consist simply of drawing a straight line
through the approximate mid-points of past market swings and
then planning to buy somewhere below this line and to sell some¬
where above it.

Perhaps such a “system” would be as practical as any, but
the analyst is likely to insist on a more scientific approach. One
possible refinement would operate as follows:

1. Select a diversified list of leading industrial common stocks.

2. Determine a base or “normal” value for the group by capitalizing
their average earnings at some suitable figure, related to the going long-term
interest rate.

3. Determine a buying point at some percentage below this normal
value and a selling point above it. (Or buying and selling may be done “on
a scale down” and “on a scale up.”)

A method of this kind has plausible logic to recommend it, and
it is favored also by an age-old tradition that success in the stock
market is gained by buying at depressed levels and selling out
when the public is optimistic. But the reader will suspect at once
that there is a catch to it somewhere. What are its drawbacks?

As we see it, the difficulties attending this idea are threefold:
First, although the general pattern of the market's behavior may
be properly anticipated, the specific buying and selling points may
turn out to have been badly chosen, and the operator may miss
his opportunity at one extreme or the other. Second, there is

370

SECURITY ANALYSIS

always a chance that the character of the market's behavior may
change significantly, so that a scheme of operation that would
have worked well in the past will cease to be practicable. Third,
the method itself requires a considerable amount of human
fortitude. It generally involves buying and selling when the
prevalent psychology favors the opposite course, watching one's
shares go lower after purchase and higher after sale and often
staying out of the market for long periods ( e.g ., 1927-1930)
when most people are actively interested in stocks. But despite
these disadvantages, which we do not minimize, it is our view that
this method has a good deal to commend it to those tempera¬
mentally qualified to follow it.

The Undervalued-individual-issue Approach .—The other appli¬
cation of the principle of investing in undervalued common
stocks is directed at individual issues, which upon analysis appear
to be worth substantially more than they are selling foi. It is
rare that a common stock will appear satisfactory from every
qualitative angle and at the same time will be found to be selling
at a low price by such quantitative standards as earnings, divi¬
dends, and assets. Issues of this type would undoubtedly be
eligible for a group purchase that would fulfill our supplementary
criterion of “investment” given in Chap. IV. (“An invest¬
ment operation is one that can be justified on both qualitative
and quantitative grounds.”)

Of more practical importance is the question whether or not
investment can be successfully carried on in common stocks that
appear cheap from the quantitative angle and that—upon study
—seem to have average prospects for the future. Securities of
this type can be found in reasonable abundance, as a result of the
stock market's obsession with companies considered to have
unusually good prospects of growth . Because of this emphasis on
the growth factor, quite a number of enterprises that are long
established, well financed, important in their industries and
presumably destined to stay in business and make profits indefi¬
nitely in the future, but that have no speculative or growth
appeal, tend to be discriminated against by the stock market—
especially in years of subnormal profits—and to sell for cor *-
siderably less than the business would be worth to a private owner . 1

1 Note that we have applied the touchstone of “value to a private inves¬
tor” to justify two different types of investment in common stocks: a)

THEORY OF COMMON-STOCK INVESTMENT

371

We incline strongly to the belief that this last criterion—a
price far less than value to a private owner—will constitute a
sound touchstone for the discovery of true investment opportuni¬
ties in common stocks. This view runs counter to the convic¬
tions and practice of most people seeking to invest in equities,
including practically all the investment trusts. Their emphasis
is mainly on long-term growth, prospects for the next year, or the
indicated trend of the stock market itself. Undoubtedly any
of these three viewpoints may be followed successfully by
those especially well equipped by experience and native ability
to exploit them. But we are not so sure that any of these
approaches can be developed into a system or technique that can
be confidently followed by everyone of sound intelligence who
has studied it with care. Hence we must raise our solitary voice
against the use of the term investment to characterize these
methods of operating in common stocks, however profitable they
may be to the truly skillful. Trading in the market, forecasting
next year’s results for various businesses, selecting the best media
for long-term expansion—all these have a useful place in Wall
Street. But we think that the interests of investors and of Wall
Street as an institution would be better served if operations
based primarily on these factors were called by some other name
than investment.

Whether or not our own concept of common-stock investment
is a valid one may be more intelligently considered after we have
given extended treatment to the chief factors that enter into a
statistical analysis of a stock issue. The need for such analysis
is quite independent of our investment philosophy. After all,
common stocks exist and are actively dealt in by the public.
Those who buy and sell will properly seek to arm themselves
with an adequate knowledge of financial practice and with the
tools and technique necessary for an intelligent analysis of cor¬
porate statements.

Such information and equipment for the common-stock
investor form the subject matter of the following chapters.

purchase of issues thought to have exceptional prospects at no higher price
than would be paid for a corresponding interest in a private business and
(2) purchase of issues with good records and average prospects at a much
lower price than the business is worth to a private owner. See Appendix
Note 45, p. 769, for the exhibit of an issue of the latter type. (Swift and
Company).

CHAPTER XXIX

THE DIVIDEND FACTOR IN COMMON-STOCK
ANALYSIS

A natural classification of the elements entering into the valua¬
tion of a common stock would be under the three headings:

1. The dividend rate and record.

2. Income-account factors (earning power).

3. Balance-sheet factors (asset value).

The dividend rate is a simple fact and requires no analysis, but
its exact significance is exceedingly difficult to appraise. From
one point of view the dividend rate is all-important, but from
another and equally valid standpoint it must be considered an
accidental and minor factor. A basic confusion has grown up
in the minds of managements and stockholders alike as to what
constitutes a proper dividend policy. The result has been to
create a definite conflict between two aspects of common-stock
ownership: one being the possession of a marketable security,
and the other being the assumption of a partnership interest in a
business. Let us consider the matter in detail from this twofold
approach.

Dividend Return as a Factor in Common-stock Investment.—

Until recent years the dividend return was the overshadowing
factor in common-stock investment. * This point of view was
based on simple logic. The prime purpose of a business corpora¬
tion is to pay dividends to its owners. A successful company
is one that can pay dividends regularly and presumably increase
the rate as time goes on. Since the idea of investment is closely
bound up with that of dependable income, it follows that invest¬
ment in common stocks would ordinarily be confined to those
with a well-established dividend. It would follow also that
the price paid for an investment common stock would be deter¬
mined chiefly by the amount of the dividend.

372

THEORY OF COMMON-STOCK INVESTMENT

373

We have seen that the traditional common-stock investor
sought to place himself as nearly as possible in the position of
an investor in a bond or a preferred stock. He aimed primarily
at a steady income return, which in general would be both
somewhat larger and somewhat less certain than that provided
by good senior securities. Excellent illustrations of the effect
of this attitude upon the price of common stocks are afforded
by the records of the earnings, dividends and annual price
variations of American Sugar Refining between 1907 and 1913
and of Atchison, Topeka and Santa Fe Railway between 1916
and 1925 presented herewith.

American Sugar Refining Company

Year

Range for stock

Earned per share

Paid per share

138- 93

$10 22

$7 00

1908

138- 99

7.45

7.00

1909

136-115

14 20

7.00

1910

128-112

5.38

7.00

1911

123-113

18 92

7.00

1912

134-114

5 34

7.00

1913

118-100

0.02(d)

7.00

Atchison, Topeka and Santa Fe Railway Company

Year

Range for
stock

Earned per share

Paid per share

1916

109-100

$14 74

1917

108- 75

14 50

1918

100- 81

10.59*

1919

104- 81

15.41*

1920

90- 76

12 54*

1921

94- 76

14 691

1922

109- 92

12.41

1923

105- 94

15.48

1924

121- 97

15.47

1925

141-116

17.19

* Results for these years based on actual operations. Results of federal operation were:
1918 —$ 9 . 98 ; 1919 -—$ 16 . 55 ; 1920 —$ 13 . 98 .

t Includes nonrecurrent income. Excluding the latter the figure for 1921 would have
been $11.29.

The market range of both issues is surprisingly narrow, con¬
sidering the continuous gyrations of the stock market generally

374

SECURITY ANALYSIS

during those periods. The most striking feature of the exhibit
is the slight influence exercised both by the irregular earnings
of American Sugar and by the exceptionally well-maintained and
increasing earning power on the part of Atchison. It is clear
that the price of American Sugar was dominated throughout by
its $7 rate and that of Atchison by its $6 rate, even though the
earnings records would apparently have justified an entirely
different range of relative market values.

Established Principle of Withholding Dividends.—We have,
therefore, on the one hand an ingrained and powerfully motivated
tradition which centers investment interest upon the present and
past dividend rate. But on the other hand we have an equally
authoritative and well-established principle of corporate manage¬
ment which subordinates the current dividend to the future
welfare of the company and its shareholders. It is considered
proper managerial policy to withhold current earnings from
stockholders, for the sake of any of the following advantages:

1. To strengthen the financial (working-capital) position.

2. To increase productive capacity.

3. To eliminate an original overcapitalization.

When a management withholds and reinvests profits, thus
building up an accumulated surplus, it claims confidently to
be acting for the best interests of the shareholders. For by
this policy the continuance of the established dividend rate is
undoubtedly better assured, and furthermore a gradual but
continuous increase in the regular payment is thereby made
possible. The rank and file of stockholders will give such policies
their support, either because they are individually convinced
that this procedure redounds to their advantage or because they
accept uncritically the authority of the managements and bankers
who recommend it.

But this approval by stockholders of what is called a “ con¬
servative dividend policy ” has about it a peculiar element of the
perfunctory and even the reluctant. The typical investor
would most certainly prefer to have his dividend today and let
tomorrow take care of itself. No instances are on record in
which the withholding of dividends for the sake of future profits
has been hailed with such enthusiasm as to advance the price
of the stock. The direct opposite has invariably been true.

THEORY OF COMMON-STOCK INVESTMENT 375

Given two companies in the same general position and with the
same earning power t the one paying the larger dividend will always
sell at the higher price .

Policy of Withholding Dividends Questionable. —This is an
arresting fact, and it should serve to call into question the
traditional theory of corporate finance that the smaller the
percentage of earnings paid out in dividends the better for
the company and its stockholders. Although investors have been
taught to pay lip service to this theory, their instincts—and
perhaps their better judgment—are in icvolt against it. If we
try to bring a fresh and critical viewpoint to bear upon this
subject, we shall find that weighty objections may be leveled
against the accepted dividend policy of American corporations.

Examining this policy more closely, we see that it rests upon
two quite distinct assumptions. The first is that it is advanta¬
geous to the stockholders to leave a substantial part of the annual
earnings in the business; the second is that it is desirable to
maintain a steady dividend rate in the face of fluctuations in
profits. As to the second point, there would be no question at
all, provided the dividend stability is achieved without too great
sacrifice in the amount of the dividend. Assume that the earn¬
ings vary between $5 and $15 annually over a period of years,
averaging $10. No doubt the stockholder's advantage would be
best served by maintaining a stable dividend rate of $8, some¬
times drawing upon the surplus to maintain it, but on the average
increasing the surplus at the rate of $2 per share annually.

This would be an ideal arrangement. But in practice it is
rarely followed. We find that stability of dividends is usually
accomplished by the simple expedient of paying out a small part
of the average earnings. By a rcductio ad absurdum it is clear
that any company that earned $10 per share on the average
could readily stabilize its dividend at $1. The question arises
very properly if the shareholders might not prefer a much larger
aggregate dividend, even with some irregularity. This point is
well illustrated in the case of Atchison.

The Case of Atchison. —Atchison maintained its dividend at
the annual rate of $6 for the 15 years between 1910 and 1924.
During this time the average earnings were in excess of $12 per
share, so that the stability was attained by withholding over
half the earnings from the stockholders. Eventually this policy

376

SECURITY ANALYSIS

bore fruit in an advance of the dividend to $10, which rate was
paid between 1927 and 1931, and was accompanied by a rise
in the market price to nearly $300 per share in 1929. Within
six months after the last payment at the $10 rate (in December
1931) the dividend was omitted entirely. Viewed critically,
the stability of the Atchison dividend between 1910 and 1924
must be considered as of dubious benefit to the stockholders.
During its continuance they received an unduly small return
in relation to the earnings; when the rate was finally advanced,
the importance attached to such a move promoted excessive
speculation in the shares; finally, the reinvestment of the enor¬
mous sums out of earnings failed to protect the shareholders
from a complete loss of income in 1932. Allowance must be
made, of course, for the unprecedented character of the depres¬
sion in 1932. But the fact remains that the actual operating
losses in dollars per share up to the passing of the dividend were
entirely insignificant in comparison with the surplus accumulated
out of the profits of previous years.

United States Steel , Another Example .—The Atchison case
illustrates the two major objections to what is characterized
and generally approved of as a “conservative dividend policy.”
The first objection is that stockholders receive both currently
and ultimately too low a return in relation to the earnings of their
property; the second is that the “saving up of profits for a rainy
day” often fails to safeguard even the moderate dividend rate
when the rainy day actually arrives. A similarly striking
example of the ineffectiveness of a large accumulated surplus is
shown by that leading industrial enterprise, United States Steel.

The following figures tell a remarkable story:

Profits available for the common stock,

1901-1930.$2,344,000,000

Dividends paid:

Cash. 891,000,000

Stock . 203,000,000

Undistributed earnings. 1,250,000,000

Loss after preferred dividends Jan. 1, 1931-

June 30, 1932 . 59,000,000

Common dividend passed June 30, 1932.

A year and a half of declining business was sufficient to out¬
weigh the beneficial influence of 30 years of practically continuous
reinvestment of profits.

THEORY OF COMMON-STOCK INVESTMENT

377

The Merits of “Plowing-back” Earnings* —These examples
serve to direct our critical attention to the other assumption on
which American dividend policies are based, viz ., that it is
advantageous to the stockholders if a large portion of the annual
earnings are retained in the business. This may well be true,
but in determining its truth a number of factors must be con¬
sidered that are usually left out of account. The customary
reasoning on this point may be stated in the form of a syllogism,
as follows:

Major premise—Whatever benefits the company benefits the stockholders.

Minor premise—A company is benefited if its earnings are retained rather
than paid out in dividends.

Conclusion—Stockholders are benefited by the withholding of corporate
earnings.

The weakness of the foregoing reasoning rests of course in the
major premise. Whatever benefits a business benefits its owners,
provided the benefit is not conferred upon the corporation at the
expense of the stockholders. Taking money away from the
stockholders and presenting it to the company will undoubtedly
strengthen the enterprise, but whether or not it is to the owners’
advantage is an entirely different question. It is customary
to commend managements for “plowing earnings back into the
property”; but, in measuring the benefits from such a policy,
the time element is usually left out of account. It stands to
reason that, if a business paid out only a small part of its earnings
in dividends, the value of the stock should increase over a period
of years, but it is by no means so certain that this increase will
compensate the stockholders for the dividends withheld from
them, particularly if interest on these amounts is compounded .

An inductive study would undoubtedly show that the earning
power of corporations does not in general expand proportionately
with increases in accumulated surplus. Assuming that the
reported earnings were actually available for distribution , then
stockholders in general would certainly fare better in dollars and
cents if they drew out practically all of these earnings in divi¬
dends. An unconscious realization of this fact has much to do
with the tendency of common stocks paying liberal dividends
to sell higher than others with the same earning power but
paying out only a small part thereof.

Dividend Policies Arbitrary and Sometimes Selfishly Deter¬
mined.— One of the obstacles in the way of an intelligent under-

378

SECURITY ANALYSIS

standing by stockholders of the dividend question is the accepted
notion that the determination of dividend policies is entirely a
managerial function, in the same way as the general running
of the business. This is legally true, and the courts will not
interfere with the dividend action or inaction except upon an
exceedingly convincing showing of unfairness. But if stock¬
holders’ opinion were properly informed, it would insist upon
curtailing the despotic powers given the directorate over the
dividend policy. Experience shows that these unrestricted
powers are likely to be abused and for various reasons. Boards
of directors usually consist largely of executive officers and their
friends. The officers are naturally desirous of retaining as much
cash as possible in the treasury, in order to simplify their financial
problems; they are also inclined to expand the business persist¬
ently for the sake of personal aggrandizement and to secure
higher salaries. This is a leading cause of the unwise increase
of manufacturing facilities which has proved recurrently one of
the chief unsettling factors in our economic situation.

The discretionary power over the dividend policy may also be
abused in more sinister fashion, sometimes to permit the acquisi¬
tion of shares at an unduly low price, at other times to facilitate
unloading at a high quotation. The heavy surtaxes imposed
upon large incomes frequently make it undesirable from the
standpoint of the large stockholders that earnings be paid out in
dividends. Hence dividend policies may be determined at times
from the standpoint of the taxable status of the large stockholders
who control the directorate. This is particularly true in cases
where these dominant stockholders receive substantial salaries
as executives. In such cases they are perfectly willing to leave
their share of the earnings in the corporate treasury, since tho
latter is under their control and since by so doing they retain
control over the earnings accruing to the other stockholders as
well.

Arbitrary Control of Dividend Policy Complicates Analysis of
Common Stocks.—Viewing American corporate dividend policies
as a whole, it cannot be said that the virtually unlimited power
given the management on this score has redounded to the benefit
of the stockholders. In entirely too many cases the right to
pay out or withhold earnings at will is exercised in an unintelligent
or inequitable manner. Dividend policies are often so arbitrarily

THEORY OF COMMON-STOCK INVESTMENT

379

managed as to introduce an additional uncertainty in the
analysis of a common stock. Besides the difficulty of judging
the earning power, there is the second difficulty of predicting
what part of the earnings the directors will see fit to disburse in
dividends.

It is important to note that this feature is peculiar to American
corporate finance and has no close counterpart in the other
important countries. The typical English, French or German
company pays out practically all the earnings of each year,
except those carried to reserves. 1 Hence they do not build up
large profit-and-loss surpluses, such as are common in the United
States. Capital for expansion purposes is provided abroad
not out of undistributed earnings but through the sale of addi¬
tional stock. To some extent, perhaps, the reserve accounts
shown in foreign balance sheets will serve the same purpose as
an American surplus account, but these reserve accounts rarely
attain a comparable magnitude.

Plowing Back due to Watered Stock.—The American theory
of “plowing back” earnings appears to have grown out of the
stock-watering practices of prewar days. Many of our large
industrial companies made their initial appearance with no
tangible assets behind their common shares and with inadequate
protection for their preferred issues. Hence it was natural that
the management should seek to make good these deficiencies
out of subsequent earnings. This was particularly true because
additional stock could not be sold at its par value, and it was
difficult therefore to obtain new capital for expansion except
through undistributed profits.*

Examples: Concrete examples of the relation between over-
capitalization and dividend policies are afforded by the outstand¬
ing cases of Woolworth and United States Steel Corporation.

In the original sale of F. W. Woolworth Company shares to the
public, made in 1911, the company issued preferred stock to
represent all the tangible assets and common stock to represent
the good-will. The balance sheet accordingly carried a good-will
item of $50,000,000 among the assets, offsetting a corresponding
liability for 500,000 shares of common, par $100. 3 As Wool-

1 See Appendix Note 46, p. 772, for discussion and examples.

* The no-par-value device is largely a post-1918 development.

1 This was for many years a standard scheme for financing of industrial

380

SECURITY ANALYSIS

worth prospered, a large surplus was built up out of earnings, and
amounts were charged against this surplus to reduce the good-will
account, until finally it was written down to SI. 1

In the case of United States Steel Corporation, the original
capitalization exceeded tangible assets by no less than $768,-
000,000, representing all the common and more than half the
preferred stock. This “water” in the balance sheet was not
shown as a good-will item, as in the case of Wool worth, but was
concealed by an overvaluation of the fixed assets (i.e., of the
“Property Investment Accounts”). Through various account¬
ing methods, however, the management applied earnings from
operations to the writing off of these intangible or fictitious assets.
By the end of 1929 a total of $508,000,000—equal to the entire
original common-stock issue—had been taken from earnings or
surplus and deducted from the property account. The balance
of $260,000,000 was set up separately as an intangible asset in
the 1937 report and then written off entirely in 1938 by means of
a reduction in the stated value of the common stock.

Some of the accounting policies above referred to will be dis¬
cussed again, with respect to their influence on investment values,
in our chapters on Analysis of the Income Account and Balance-
sheet Analysis. From the dividend standpoint it is clear that in
both of these examples the decision to retain large amounts of
earnings, instead of paying them out to the stockholders, was
due in part to the desire to eliminate intangible items from the
asset accounts.

Conclusions from the Foregoing.—From the foregoing discus¬
sion certain conclusions may be drawn. These bear, first on the
very practical question of what significance should be accorded
the dividend rate as compared with the reported earnings and,
secondly, upon the more theoretical but exceedingly important
question of what dividend policies should be considered as most
desirable from the standpoint of the stockholders' interest.

companies. It was followed by Sears Roebuck, Cluett Peabody, National
Cloak and Suit and others.

1 It should be noted that when the good-will of Woolworth was originally
listed in the balance sheet at $50,000,000, its actual value (as measured by
the market price of the shares) was only some $20,000,000. But when the
good-will was written down to $1, in 1925, its real value was apparently
many times $50,000,000.

THEORY OF COMMON-STOCK INVESTMENT

381

Experience would confirm the established verdict of the stock
market that a> dollar of earnings is worth more to the stockholder
if paid him in dividends than when carried to surplus. The
common-stock investor should ordinarily require both an
adequate earning power and an adequate dividend. If the
dividend is disproportionately small, an investment purchase will
be justified only on an exceptionally impressive showing of
earnings (or by a very special situation with respect to liquid
assets). On the other hand, of course, an extra-liberal dividend
policy cannot compensate for inadequate earnings, since with such
a showing the dividend rate must necessarily be undependable.

To aid in developing these ideas quantitatively, we submit
the following definitions:

The dividend rate is the amount of annual dividends paid per
share, expressed either in dollars or as a percentage of a $100 par
value. (If the par value is less than $100, it is inadvisable to
refer to the dividend rate as a percentage figure since this may
lead to confusion.)

The earnings rate is the amount of annual earnings per share,
expressed either in dollars or as a percentage of a $100 par value.

The dividend ratio, dividend return or dividend yield, is the
ratio of the dividend paid to the market price ( e.g., a stock
paying $6 annually and selling at 120 has a dividend ratio of 5%).

The earnings ratio, earnings return or earnings yield, is the ratio
of the annual earnings to the market price {e.g., a stock earning
$6 and selling at 50 shows an earnings yield of 12%). 1

Let us assume that a common stock A, with average prospects,
earning $7 and paying $5 should sell at 100. This is a 7%
earnings ratio and 5% dividend return. Then a smilar common
stock, B, earning $7 but paying only $4, should sell lower than
100. Its price evidently should be somewhere between 80 (repre¬
senting a 5% dividend yield) and 100 (representing a 7% earnings
yield). In general the price should tend to be established nearer
to the lower limit than to the upper limit. A fair approximation
of the proper relative price would be about 90, at which level the
dividend yield is 4.44%, and the earnings ratio is 7.78%. If the
investor makes a small concession in dividend yield below

1 The term earnings basis has the same meaning as earnings ratio. How¬
ever, the term dividend basis is ambiguous, since it is used sometimes to
denote the rate and sometimes the ratio.

382

SECURITY ANALYSIS

the standard^ he is entitled to demand a more than corresponding
increase in the earning power above standard.

In the opposite case a similar stock, C, may earn $7 but pay
$6. Here the investor is justified in paying some premium
above 100 because of the larger dividend. The upper limit, of
course, would be 120 at which price the dividend ratio would
be the standard 5%, but the earnings ratio would be only 5.83%.
Here again the proper price should be closer to the lower than
to the upper limit, say, 108, at which figure the dividend yield
would be 5.56% and the earnings ratio 6.48%.

Suggested Principle for Dividend Payments.—Although these
figures are arbitrarily taken, they correspond fairly well with
the actualities of investment values under what seem now to be
reasonably normal conditions in the stock market. The divi¬
dend rate is seen to be important, apart from the earnings, not
only because the investor naturally wants cash income from his
capital but also because the earnings that are not paid out in divi¬
dends have a tendency to lose part of their effective value for
the stockholder. Because of this fact American shareholders
would do well to adopt a different attitude than hitherto
with respect to corporate dividend policies. We should suggest
the following principle as a desirable modification of the tradi¬
tional viewpoint:

Principle: Stockholders are entitled to receive the earnings on
their capital except to the extent they decide to reinvest them
in the business. The management should retain or reinvest
earnings only with the specific approval of the stockholders.
Such “earnings” as must be retained to protect the company's
position are not true earnings at all. They should not be reported
as profits but should be deducted in the income statement as
necessary reserves, with an adequate explanation thereof. A
compulsory surplus is an imaginary surplus. 1

Were this principle to be generally accepted, the withholding
of earnings would not be taken as a matter of course and of
arbitrary determination by the management, but it would require
justification corresponding to that now expected in the case of
changes in capitalization and of the sale of additional stock.
The result would be to subject dividend policies to greater
scrutiny and more intelligent criticism than they now receive,

1 We refer here to a surplus which had to be accumulated in order to main¬
tain the company’s status, and not to a surplus accumulated as a part of
good management.

THEORY OF COMMON-STOCK INVESTMENT

883

thus imposing a salutary check upon the tendency of manage¬
ments to expand unwisely and to accumulate excessive working
capital. 1

If it should become the standard policy to disburse the major
portion of each year's earnings (as is done abroad), then the rate
of dividend will vary with business conditions. This would
apparently introduce an added factor of instability into stock
values. But the objection to the present practice is that it fails
to produce the stable dividend rate which is its avowed purpose
and the justification for the sacrifice it imposes. Hence instead
of a dependable dividend that mitigates the uncertainty of
earnings we have a frequently arbitrary and unaccountable
dividend policy that aggravates the earnings hazard. The
sensible remedy would be to transfer to the stockholder the task
of averaging out his own annual income return. Since the
common-stock investor must form some fairly satisfactory
opinion of average earning power, which transcends the annual
fluctuations, he may as readily accustom himself to forming a
similar idea of average income . As in fact the two ideas are
substantially identical, dividend fluctuations of this kind would
not make matters more difficult for the common-stock investor.
In the end such fluctuations will work out more to his advantage
than the present method of attempting, usually unsuccessfully,
to stabilize the dividend by large additions to the surplus account. 2
On the former basis, the stockholder's average income would
probably be considerably larger.

A Paradox .—Although we have concluded that the payment of
a liberal portion of the earnings in dividends adds definitely to the
attractiveness of a common stock, it must be recognized that this

1 The suggested procedure under the British Companies Act of 1929
requires that dividend payments be approved by the shareholders at their
annual meeting but prohibits the approval of a rate greater than that
recommended by the directors. Despite the latter proviso, the mere fact
that the dividend policy is submitted to the stockholders for their specific
approval or criticism carries an exceedingly valuable reminder to the
management of its responsibilities, and to th° owners of their rights, on this
important question.

Although this procedure is not required by the Companies Act in aU
cases, it is generally followed in England. See Companies Act of 1929,
Sections 6-10; Table A to the Companies Act of 1929, pars. 89-93; Palmer'*
Company Law, pp. 222-224, 13th ed., 1929.

1 For a comprehensive study of the effects of withholding earnings on the
regularity of dividend payments, see 0. J. Curry, Utilization of Corporate
Profile in Proeperity and Depression , Ann Arbor, 1941.

384

SECURITY ANALYSIS

conclusion involve/ a curious paradox. Value is increased by
taking away value. The more the stockholder subtracts in
dividends from the capital and surplus fund the larger value he
places upon what is left. It is like the famous legend of the
Sibylline Books, except that here the price of the remainder is
increased because part has been taken away.

This point is well illustrated by a comparison of Atchison and
Union Pacific—two railroads of similar standing—over the ten-
year period between January 1, 1915, and December 31, 1924.

Item

Earned, 10 years 1915-1924.

Net adjustments in surplus account.

Total available for stockholders .

Dividends paid.

Increase in market price.

Total realizable by stockholders .

Increase in earnings, 1924 over 1914....

Increase in book value, 1924 over 1914. .

Increase in dividend rate, 1924 over 1914
Increase in market price, 1924 over 1914.

Market price, Dec. 31, 1914.

Market price, Dec. 31, 1924.

Earnings, year ended June 30, 1914 ....

Earnings, calendar year 1924.

* Excluding about $7 per share transferred from reserves to surplus,
t Calendar year 1924 compared with year ended June 30, 1914.

It is to be noted that because Atchison failed to increase its
dividend the market price of the shares failed to reflect adequately
the large increase both in earning power and in book value. The
more liberal dividend policy of Union Pacific produced the
opposite result.

This anomaly of the stock market is explained in good part by
the underlying conflict of the two prevailing ideas regarding
dividends which we have discussed in this chapter. In the
following brief summary of the situation we endeavor to indicate
the relation between the theoretical and the practical aspects of
the dividend question.

Per share of common

Union Pacific

Atchison

$142.00

$137

dr. 1.50*

cr. 13

$140.50

$150

$ 97.50

$ 60

33.00

$130.50

$ 85

9%t

109 % f

25%

70%

25%

none

28%

27%

116

149

118

$ 13.10

$ 7.40

14.30

15.45

THEORY OF COMMON-STOCK INVESTMENT

385

Summary. — 1. In some cases the stockholders derive positive
benefits from an ultraconservative dividend policy, i.e., through
much larger eventual earnings and dividends. In such instances
the market's judgment proves -to be wrong in penalizing the
shares because of their small dividend. The price of these shares
should be higher rather than lower on account of the fact that
profits have been added to surplus instead of having been paid
out in dividends.

2. Far more frequently, however, the stockholders derive
much greater benefits from dividend payments than from
additions to surplus. This happens because either: (a) the
reinvested profits fail to add proportionately to the earning
power or ( b ) they are not true “profits" at all but reserves that
had to be retained merely to protect the business. In this
majority of cases the market's disposition to emphasize the
dividend and to ignore the additions to surplus turns out to be
sound.

3. The confusion of thought arises from the fact that the
stockholder votes in accordance with the first premise and
invests on the basis of the second. If the stockholders asserted
themselves intelligently, this paradox would tend to disappear.
For in that case the withholding of a large percentage of the
earnings would become an exceptional practice, subject to close
scrutiny by the stockholders and presumably approved by them
from a considered conviction that such retention would be
beneficial to the owners of the shares. Such a ceremonious
endorsement of a low dividend rate would probably and properly
dispel the stock market's scepticism on this point and permit
the price to reflect the earnings that are accumulating as well
as those which were paid out.

The foregoing discussion may appear to conflict with the
suggestion, advanced in the previous chapter, that long-term
increases in common-stock values arc often due to the reinvest¬
ment of undistributed profits. We must distinguish here between
the two lines of argument. Taking our standard case of a com¬
pany earning $10 per share and paying dividends of $7, we have
pointed out that the repeated annual additions of $3 per share
to surplus should serve to increase the value of the stock over a
period of years. This may very well be true, and at the same
time the rate of increase in value may be substantially less than

386

8ECURITY ANALYSIS

$3 per annum compounded. If we take the reverse case, viz.,
$3 paid in dividends and $7 added to surplus, the distinction
is clearer. Undoubtedly the large addition to surplus will expand
the value of the stock, but quite probably also this value will
fail to increase at the annual rate of $7 compounded. Hence
the argument against reinvesting large proportions of the
yearly earnings would remain perfectly valid. Our criticism is
advanced against the latter type of policy, e.g., the retention of
70% of the earnings, and not against the normal reinvestment of
some 30% of the profits.

Dividend Policies since 1934 . —If the dividend practice of
American corporations were to be judged solely by the record
during 1934-1939, the criticism expressed in this chapter would
have to be softened considerably. In these recent years there
has been a definite tendency towards greater liberality in dividend
payments, particularly by companies that do not have clearly
defined opportunities for profitable expansion. Retention of
earnings by rapidly growing enterprises, e.g., airplane manu¬
facturers, is hardly open to objection. Since the end of 1932, on
the other hand, General Motors Corporation has disbursed about
80% of earnings to common-stock holders, with no wide deviation
in any year through 1939. In 1939 the Treasury Department
announced that it would use 70% as a rough or preliminary test
to decide whether or not a company is subject to the penalty
taxes for improper accumulation of surplus.

As far as stock prices are concerned, it can hardly be said that
they have been unduly influenced by arbitrary dividend policies
in these recent years. For not only have the policies themselves
been far less arbitrary than in former times, but there has been a
definite tendency in the stock market to subordinate the dividend
factor to the reported and prospective earnings.

The Undistributed-profits Tax.—The more liberal dividends
of recent years have been due in part to the highly controversial
tax on undistributed profits. This was imposed by Congress in
1936, on a graduated scale running from 7 to 27%. Following
violent criticism, the tax was reduced to a vestigial 2%% in 1938
and repealed entirely the following year. Its main object was to
compel companies to distribute their earnings, so that they might
be subject to personal income taxes levied against the stock¬
holders. A secondary objective appears to have been to restrict

THEORY OF COMMON-STOCK INVESTMENT 387

che accumulation of corporate surpluses, which were thought by
some to be injurious, either because they withheld purchasing
power from individuals or because they were conducive to unwise
expansion. But the tax was widely and violently condemned,
chiefly on the ground that it prevented the creation of surplus
or reserve funds essential to meet future losses or emergencies or
expansion needs. It was said to lay a heavy penalty on corporate
thrift and prudence and to bear with particular severity on small
or new corporations which must rely largely on retained profits
for their growth.

Law Objectionable but Criticized on Wrong Grounds .—In our
own opinion the law was a very bad one, but it has been criticized
largely on the wrong grounds. Its objective, as first announced,
was to tax corporations exactly as if they were partnerships and
hence to equalize the taxation basis of corporate and unincor¬
porated businesses. Much could be said in favor of this aim.
But as the bill was finally passed it effectively superposed part¬
nership taxation on top of corporate taxation, thus heavily
discriminating against the corporate form and especially against
small stockholders. Nor was it a practicable tax as far as
wealthy holders were concerned, because the extremely high
personal tax rates, combined with the corporation taxes (state
and federal), created an over-all burden undoubtedly hostile to
individual initiative. Fully as bad were the technical details of
the tax law, which compelled distributions in excess of actual
accounting profits, disregarded very real capital losses and
allowed no flexibility in the treatment of inventory values.

Despite the almost universal opinion to the contrary, we do
not believe that the undistributed profits tax really prevented the
reinvestment of earnings, except to the extent that these were
diminished by personal income taxes—as they would be in an
unincorporated business. Corporations had available a number
of methods for retaining or recovering these earnings, without
subjecting them to the penalty tax. These devices included
(1) declaration of taxable stock dividends ( e.g ., in preferred
stock); (2) payment of “optional” dividends, so contrived as
to impel the stockholders to take stock rather than cash; (3)
offering of additional stock on attractive terms at the time of
payment of cash dividends. Critics of the tax have asserted
that these methods are inconvenient or impracticable. Our own

388

SECURITY ANALYSIS

observation is that they were quite practicable and were resorted
to by a fair number of corporations in 1936 and 1937, 1 but that
they were avoided by the majority, cither from unfamiliarity
or from a desire to throw as harsh a light as possible upon the law.

Proper Dividend Policy .—In view of the scepticism that we
have expressed as to whether or not stockholders are really
benefited by dividend-withholding policies, we may be thought
sympathetic to the idea of preventing reinvestment of profits
by imposing penalty taxes thereon. This is far from true.
Dividend and reinvestment policies should be controlled not by
law but by the intelligent decision of stockholders. Individual
cases may well justify retention of earnings to an extent far
greater than is ordinarily desirable. The practice should vary
with the circumstances; the policy should be determined and pro¬
posed in the first instance by the management; but it should be
subject to independent consideration and appraisal by stock¬
holders in their own interest, as distinguished from that of the
corporation as a separate entity or the management as a special
group.

l See Rolbein, David L., “Noncash Dividends and Stock Rights as
Methods for Avoidance of the Undistributed Profits Tax,” XII The Journal
of Business of the University of Chicago 221-264, July, 1939. For more
comprehensive surveys of this tax see Alfred G. Buehler, The Undistributed
Profits Tax, New York, 1937 (an adverse appraisal), and Graham, Benjamin,
“The Undistributed Profits Tax and the Investor,” LXVI Yale Law
Journal 1-18, November, 1936, elaborating the views expressed above.

CHAPTER XXX

STOCK DIVIDENDS

Distributions made in the form of stock instead of cash are of
two kinds, which may be called extraordinary and periodic . An
extraordinary stock dividend may be defined as one that capital¬
izes part of the accumulated surplus of past years; i.e. y it transfers
a substantial amount from the accumulated surplus to stated
capital and gives the stockholders additional shares to represent
the funds thus transferred.

A periodic stock dividend may be defined as one that capital¬
izes part of only the current year's earnings. Hence it is almost
always of relatively small size. It is called periodic because such
dividends are usually repeated over a number of years in accord¬
ance with an established policy.

EXTRAORDINARY STOCK DIVIDENDS

Extraordinary stock dividends are legal and legitimate, but
by and large they produce unfortunate effects. The only reason
for such a dividend that is at once sound and practical is that
it will adjust the market price of the shares to a more convenient
level. Widespread public interest and an active market are
desirable attributes of a common stock, and these are diminished
when the normal price range has advanced to such a high figure
as, say, S300 or $400 per share. Hence an increase in the number
of shares and the reduction in value of each share, by means of a
large stock dividend, would be a logical step to take.

Example: In 1917 Bethlehem Steel stock was selling above
$500 per share. A stock dividend of 200% was paid (and addi¬
tional shares were sold at par) bringing the market price down
to about 150.

Split-ups.—Exactly the same result may be obtained by reduc¬
ing the par value of the shares, such a move being referred to
familiarly as a “split-up.” During the bull market of the 1920's

389

300

SECURITY ANALYSIS

reductions in par value were much more frequent than large
stock dividends on stocks with par value, because the rise in
market price had so far outstripped the accumulated surplus
that a distribution of the latter would have been insufficient for
the purpose.

Example: In 1926 General Electric stock was selling at 360.
Four new shares of no-par value were given for each old share of
$100 par value, thus reducing the market price to about 90. To
have effected the same result by a 300% stock dividend would
have required the transfer of 540 millions from surplus to capital,
but the surplus was then only 100 millions. A similar situation
existed in 1930 when General Electric shares were again split
four for one.

In the case of Woolworth, the original common issue of 500,000
shares was increased to 9,750,000 shares by the following steps,
involving both stock dividends and split-ups.

Total Shares
Outstanding

1920: Stock dividend of 30%, reducing the price

from about 140 to about 110. 650,000

1924: Par value cut from $100 to $25, reducing the

price from about 320 to about 80. 2,600,000

1927: Stock dividend of 50%, reducing the price

from about 180 to about 120 . 3,900,000

1929: Par value cut from $25 to $10, reducing the
price from about 225 to about 90 . 9,750,000

American Can combined both devices at one time in 1926. It
reduced the par value from $100 to $25 and also paid a stock
dividend of 50%. Hence six shares were issued for one, and tho
price was reduced from about 300 to about 50.

Stock Splits and Stock Dividends in No-par Stock.—In the
case of common stocks of no-par value, a split-up or a stock
dividend leads to exactly the same results, and to all practical
purposes they are indistinguishable. Although a stock dividend
requires the transfer of a certain sum on the books from surplus
to capital, the infinite latitude in accounting permitted by no-par
stock may make this transfer a purely nominal affair.

Examples: Central States Electric Corporation paid a 900%
stock dividend in 1926, increasing the number of shares (no par)
from 109,000 to 1,090,000. The old stock had a book value of

THEORY OF COMMON-STOCK INVESTMENT

391

about $44 per share at the end of 1925, but the new stock was
charged against surplus at the rate of only $1 per share.

Similarly in 1929, the Coca-Cola Company paid a 100% stock
dividend in Class A stock without par value. This stock was
booked at $5 per share (lower than the stated value of the com¬
mon) despite the fact that the Class A stock has all of the charac¬
teristics of a $50-par, 6% preferred issue, except formal designa¬
tion of such a par figure. (See also the accounting by this
company of its 100% dividend payable in common stock in
1927, and also our discussion of its treatment of repurchases of
Class A shares in Chap. XLII.)

Objections to Extraordinary Stock Dividends and Split-ups.—
Extraordinary stock dividends and stock split-ups are both
open to the serious objection that their declaration exercises
an undue influence upon market prices and hence that they
afford an avenue for manipulation and for unfair profits by
insiders. It is obvious that in theory a large stock dividend
gives the stockholder nothing that he did not own before. His
two pieces of paper now represent the same ownership formerly
expressed by one piece of paper. This reasoning led the United
States Supreme Court to decide that stock dividends are not
income and consequently not subject to income tax. 1 In prac¬
tice, however, a stock dividend may readily be given exceptional
speculative importance. For stock speculation is largely a
matter of A trying to decide what B } C and D are likely to
think—with J3, C and D trying to do the same. Hence a stock
dividend, even if it has no real significance of any kind, can and
does serve as a stimulus to that mutual attempt at taking advan¬
tage of each other which often lies at the bottom of speculators’
activities. 2

1 This was the famous Eisner vs. Macomber decision in 1920 (252 U. S.
189). In 1936 the Supreme Court decided, in the Koshland case (297
U. S. 702), that stock dividends that gave the stockholder a different
pro-rata interest than ho had before were taxable. Under a ruling of the
Board of Tax Appeals this would apply, for example, to a dividend payable
in preferred stock of which some was previously outstanding.

1 Compare the amusing and edifying simile of J. M. Keynes: M . . . pro¬
fessional investment may be likened to those newspaper competitions in
which the competitors have to pick out the six prettiest faoes from a hundred
photographs, the prize being awarded to the competitor whose ohoice most

392

SECURITY ANALYSIS

Effect on the Cash Dividend Rate.—The essentially illusive
character of large stock dividends would be more evident were
it not for the fact that an investment element of real impor¬
tance may also enter into the picture. The payment of an
extraordinary stock dividend is usually the forerunner of an
increase in the regular cash dividend rate. Since investors are
legitimately interested in the cash dividend, they must necessarily
be interested also in any stock dividend, for this may have a
bearing upon the probable cash dividend. This serves to confuse
the issue and to make less obtrusive the purely manipulative
aspects of stock-dividend declarations.

The dividend history of a successful industrial corporation
frequently discloses the following sequence:

1. A protracted period of small dividends in relation to earnings, with
the upbuilding of a huge surplus.

2. The sudden payment of a large stock dividend.

3. An immediate increase in the regular cash dividend payments. 1

No policy could be more conducive to the confusion of invest¬
ment and speculative attitudes or lend itself more easily to the
taking of unfair advantage by those in control.

nearly corresponds to the average preferences of the competitors as a whole;
so that each competitor has to pick not those faces which he himself finds
prettiest, but those which he thinks likeliest to catch the fancy of the other
competitors, all of whom are looking at the problem from the same point of
view. It is not a case of choosing those which, to the best of one's judgment,
are really the prettiest, nor even those which average opinion genuinely
thinks the prettiest. We have reached the third degree where we devote
our intelligences to anticipating what average opinion expects the average
opinion to be. And there are some, I believe, who practice the fourth, fifth
and higher degrees.” The General Theory of Employment , Interest and
Money , p. 156, New York, 1936.

1 For example, American Can issued six shares for one in 1926 through a
four-for-one split and a 50% stock dividend. The dividend rate was $7 per
share on the old stock, but a $2 rate was immediately inaugurated on the
new stock, which was equivalent to $12 per share on the old. The rate on
the new stock was stepped up to $5 per share in 1929. Likewise National
Biscuit paid a $7 dividend annually from 1912 through 1922, although it
earned substantially in excess of that figure. The stock was split 7 for 1 in
1922 through issuing 4 new shares for each old share, followed by a 75%
stock dividend. Dividends on the new shares were inaugurated at $3 per
share, equivalent to $21 per share on the old.

THEORY OF COMMON-STOCK INVESTMENT

393

PERIODIC STOCK DIVIDENDS

This policy represents a great advance in basic soundness over
the haphazard and often inequitable practices that we have
been discussing. Such practices involve first the large accumula¬
tion of undistributed earnings in the surplus account and second
the ultimate capitalization thereof through stock dividends at
arbitrary times and in arbitrary amounts. Assuming that in
many cases it may be desirable to retain a goed part of each year’s
earnings in the business, then the interns of the stockholders
would be best served by giving them currently a tangible evi¬
dence of their ownership of these reinvested nrofits.

If an enterprise regularly earns $12 per share and pays out
only $5 in cash, the stockholders would benefit greatly by receiv¬
ing each year a stock dividend representing a good part of the $7
added to their company’s resources. In theory, of course, the
additional stock certificate gives him nothing that he would not
own without it; in other words, without a stock dividend his
old certificate would still fully represent the ownership of the
added $7 per share. But in actuality the payment of periodic
stock dividends produces important advantages. Among them
are the following:

1. The stockholder can sell the stock-dividend certificate, so that at his
option he can have either cash or more stock to represent the reinvested
earnings. Without a stock dividend he might in theory accomplish the
same end by selling a small part of the shares represented by his old certifi¬
cate, but in practice this is difficult to calculate and inconvenient in
execution.

2. He is likely to receive larger cash dividends as a result of such a policy,
because the established cash rate will usually be continued on the increased
number of shares. For example, if a company earning $12 pays out $5 in
cash and 5% in stock, in the next year it will most probably pay $5 in cash
on the new capitalization, equivalent to $5.25 on the previous holdings.
Without the stock dividend, it would probably continue the $5 rate
unchanged. 1

1 For examples of this sequence see: Cities Service Company, which paid
6% in cash and G% in stock between Mar. 1, 1925 and June 1, 1932; Sears,
Roebuck and Company which paid $2.50 per share in cash and 4% in stock
(annual rates) from the middle of 1928 through the first quarter of 1931;
Auburn Automobile Company which paid $1 ; n cash and 2% in stock
(quarterly) from January 1928 to July 1931; R. II. Macy and Company,
Inc., which during 1928-1932 paid annual stock dividends of 5% along with
increasing cash dividends.

304

SECURITY ANALYSIS

3. By adding the reinvested profits to the stated capital (instead of to
surplus) the management is placed under a direct obligation to earn money
and pay dividends on these added resources. No such accountability
exists with respect to the profit and loss surplus. The stock-dividend pro¬
cedure will serve not only as a challenge to the efficiency of the management
but also as a proper test of the wisdom of reinvesting the sums involved.

4. Issues paying periodic stock dividends enjoy a higher market value
than similar common stocks not paying such dividends.

Variations in the Practice of Periodic Stock-dividend Payment.

The practice of disbursing periodic stock dividends developed
fairly rapidly from about 1923 until the subsequent depression.
Three variations of the idea were resorted to:

1. The standard method was to pay a stock dividend in addi¬
tion to the regular cash dividend. These stock dividends were
paid either monthly, 1 quarterly, 2 semiannually 3 or annually. 4 *

2. Sometimes a periodic stock dividend was offered in lieu
of the regular cash dividend. This took the form of an option
to the stockholder to take a certain amount of either cash or
stock.

Example: The Seagrave Corporation paid a dividend quarterly
at the annual rate of either $1.20 in cash or 10% in stock between
1925 and 1929, inclusive. 6

3. In a few cases stock dividends only were paid, with no cash
disbursement or option. The most prominent exponent of
periodic stock dividends, the North American Company, followed
this procedure by paying dividends of 2^% in stock, quarterly,
between 1923 and 1933, in which latter year the payment was

1 Cities Service Company, from July 1, 1929 to June 1, 1932; Gas and
Electric Securities Company between 1926 and 1931.

* Sears, Roebuck and Company between 1928 and 1931; Auburn Auto¬
mobile Company between 1928 and 1931; Federal Light and Traction
Company between 1925 and 1932.

8 American Water Works and Electric Company between 1927 and 1930;
American Gas and Electric Company between 1914 and 1932, with addi¬
tional sporadic stock dividends; American Power and Light Company
between 1923 and 1931, with extras in stock.

4 Continental Can Company in 1924 and 1925; R. H. Macy and Company,
Inc., between 1928 and 1932; Truscon Steel Company between 1926 and

1931; General Electric Company between 1922 and 1925 (5% in special
stock).

1 Compare this arrangement with the optional dividend or interest pay¬
ments on preferred stocks and bonds, mentioned on p. 285n.

THEORY OF COMMON-STOCK INVESTMENT

395

reduced to 2% quarterly. (In 1935 the company gave up the
stock-dividend policy and returned to a cash-dividend basis.)

Objectionable Feature of Periodic Stock Dividends.—Nearly
every financial practice is open to abuse, and periodic stock divi¬
dends have proved no exception. The objectionable feature in
this case has been to establish a regular stock-dividend rate
exceeding in market value the amount of the earnings carried to
surplus. This practice makes the issue appear unduly attractive
to the unintelligent buyer, who is deceived by the high cash value
of the current payments in stock. It requires some insight into
corporate accounting methods to realize the true significance
of such stock-dividend payments.

Let us use the outstanding North American Company case
as an illustration. As we have stated, this company paid
continuous stock dividends on the common shares at the rate of
10% annually for ten years. During most of this period the
10% stock dividend represented a payment of only $1 per share,
as far as its books were concerned. This followed from the fact
that prior to 1927 the par value of the stock was $10 and that
after the shares were made no-par they were still given a “stated
value” on the books at $10 per share. Hence 10% of either
the par or the stated value amounted to only $1 per share.
But from the investor’s viewpoint he was receiving dividends
worth much more than $1 per share, because the market price
of North American common far exceeded its par or stated value.

The facts will appear from the table shown on page 396.

It will be noted that beginning with the third quarterly pay¬
ment in 1931, the amount charged against earnings for the stock
dividend was advanced from $1 to $1,468 per share annually.
This followed a request from the New York Stock Exchange
that the charge against earnings or earned surplus covering the
stock dividends reflect the interest of the new shares in the
capital surplus as well as in the stated capital. Even after this
change was made, however, there remained a wide discrepancy
between the amount at which the dividends were valued on the
books and the value given these dividends by the stock market,
and presumably by the stockholders, until the quotation suffered
a further severe decline.

Danger of Vicious Circle Developing .—An arrangement of this
kind is likely to develop into a vicious circle. The higher the

396

SECURITY ANALYSIS

Year

Earnings
per share*

Range of
market price

Value of the 10% stock dividend

Per company's
books

To the stockholders
(average market value)

1932

$2.01

43-14

$1.47

$ 2.85

1931

3.41

90-26

1.23f

5.80

1930

4.53

133-57

1.00

9.50

1929

5.03

187-67

1.00

12.70

1928

4.68

97-56

1.00

7.65

1927

4.06

65-46

1.00

5.55

1926

4.05

67-42

1.00

5.45

1925

3.74

75-41

1 00

5.80

1924

3.32

45-22

1.00

3.35

1923

3.59

24-18

1.00

2.10

* Based on the average number of shares outstanding duiing the year,
t First two quarterly dividends in 1931 wero booked at Si and last two at SI to capital
stock and 46.8 cents to capital surplus.

market price the greater the apparent value of the stock divi¬
dends, which in turn will seem to justify a still higher market
price. (With a 10% stock dividend the dividend return obvi¬
ously remains at 10% regardless of how high the market price
may climb.) Such a result is deceptive and supplies an unwhole¬
some impetus to riotous speculation as well as to thoughtless
investment. In effect it is the opposite of the practice followed
many years ago by such companies as American Can and National
Biscuit, when the market price was kept far below the true
value of the shares by an unduly “conservative” dividend
policy. It is fully as objectionable, of course, to pursue a
policy calculated to create a market price higher than that
warranted by the earnings and other value factors. Such an
unjustified price must necessarily be of temporary duration
and is likely to result (as does all improper accounting) in giving
the initiated an unfair advantage over the investing public. 1

Historical Development.—From the historical standpoint it is
interesting to note that the North American Company began
its stock-dividend policy at about the same time that the first

1 The North American Company has an excellent reputation, and its
policy was clearly not devised with any such sinister purpose in view. The
company took pains to justify its stock-dividend payments in communica¬
tions to its shareholders. Its arguments centered, however, on the advan-

THEORY OF COMMON-STOCK INVESTMENT 397

protagonist of the idea had decided to abandon it. This was
the American Light and Traction Company, which during 1910-
1919 had paid dividends at the annual rate of both $10 in cash
and 10% in stock. During 1916 when the stock sold at about
400, the stockholders were receiving dividends with a realizable
value of some $50 annually, although the earnings were only
about $25 per share. Such a dividend policy could be per¬
manently successful only if the company could continuously
reinvest in its business ever-increasing amounts of profits, upon
which in turn it could realize 20% annually. The law of dimin¬
ishing returns (and the voracious growth of compound interest)
would clearly outlaw such a possibility. In the depression
of 1920-1921 American Light and Traction found it necessary
to reduce its dividend rate sharply. The market quotation
fell below 80, an astounding decline for an investment stock
during that period. (The price range of Atchison during the
years 1916-1921 was between 109 and 76.) This experience
led the directors to give up the periodic stock-dividend idea in
1925, at the very time when it was coming into general favor
among other public-utility holding companies. The abandon¬
ment of stock dividends by North American Company ten years
later is a striking illustration of the way in which financial
history repeats itself.

Example of Vicious Pyramiding on Stock Dividends.—During
the boom years periodic stock dividends were made the medium
of an especially vicious pyramiding of reported profits. An
operating company would pay out stock dividends with a market
value more than its current earnings, and in turn an investment
trust or holding company would report these stock dividends as
income in an amount equal to the market value. For example,
Central States Electric Corporation, which is a large holder of
North American Company common stock, reported a total
income in 1928 (exclusive of profits on the sale of securities) of

tages of reinvesting earnings and on the pmpriety of issuing additional
common shares to represent these added resources. The discrepancy
between the book value and the market value of these stock dividends, and
the misconceptions that might arise therefrom, were hardly touched upon.
It was particularly unfortunate that a company of high standing should
have adopted this questionable practice, since its example was all too readily
followed and exploited by other enterprises less scrupulously managed.

398

SECURITY ANALYSIS

$7,188,178. Of this sum, $6,396,225 was represented by stock
of North American received during the year and taken on the
recipient's books at the market value for North American immedi¬
ately following the date of record for each quarterly dividend.
The average price at which these stock dividends were taken on
the books as income was $74 per share, or $7.40 for the 10%
dividend, in a year in which North American earned $4.68 per
share on the average number of shares outstanding. Neverthe¬
less, the stock market capitalized these artificial earnings of
Central States Electric Corporation to arrive at its valuation of
that company's shares. 1

Market Price of Shares Should Be Recognized in Stock-divi¬
dend Payments.—The New York Stock Exchange finally adopted
a new listing requirement under which corporations agree not to
take into their income accounts stock dividends received, at a
valuation greater than the amount at which such stock dividends
were charged “ against earnings, earned surplus or undivided
profits by the issuing company in relation thereto."

Although this regulation was properly conceived, it does not
go to the heart of the matter. The abuses of the periodic stock-
dividend procedure may be readily prevented by the simple
rule that stock dividends at market value must not exceed the
earnings available for dividends. Declarations might well be
made in the following form: “A stock dividend of 5% is hereby
declared. The market value of this dividend is approxi¬
mately $6 per share, and it represents the capitalization of $7
per share retained in the business out of current earnings of $10
per share."

Advantages of Stock Dividends Payable in Preferred Stock.—

Dividends may be paid in preferred stock instead of common
stock. The chief exemplar of this method is General Electric
Company, which distributed extra dividends of 5% annually
between 1922 and 1925, in addition to the regular payment of
$8 in cash. These extra dividends were paid in 6% special
stock, par value $10, which was in reality a preferred stock. A

1 Middle West Utilities followed a similar practice between 1928 and
April 1932 with respect to stock dividends received both from subsidiaries
and from other companies. The receivers subsequently wrote down the
corporate surplus to correct the overvaluation of these stock dividends
received from subsidiaries.

THEORY OF COMMON-STOCK INVESTMENT

399

similar procedure was followed by S. H. Kress Company and
by Hartman Corporation. The theoretical advantage of this
method is that the amount of the dividend paid is clearly fixed
at the effective par value 1 of tho preferred shares issued, thus
obviating the complication presented by differences between
book value and market value. Where the company has no
senior securities, or only a small amount, the issuance of pre¬
ferred stock to represent reinvested earnings will not weaken
the capital structure.

In 1934 General Electric Company detui mined that its work¬
ing-capital position was so comfortable as to permit the retire¬
ment of the entire issue of special stock, which was accordingly
redeemed in April 1935. This may be said to represent the
ideal arrangement from the stockholder's standpoint in dealing
with undistributed earnings. The two steps involved are as
follows:

1. In prosperous years earnings are retained for expansion or added
working capital, but the stockholders receive preferred shares periodically
to represent a portion thereof.

2. If subsequent business developments show that the additional capital
is no longer needed, it is paid out to the stockholders through the redemption
of their preferred shares.

The Foregoing Summarized.—Our conception of suitable divi¬
dend policies, discussed at length in this and the preceding
chapter, may be summed up in the following three statements: 2

1. Withholding and reinvestment of a substantial part of the earnings
must be clearly justified to the stockholders on the grounds of concrete
benefits therefrom exceeding the value of the cash if paid to the stock¬
holders. Such withholding should be specifically approved by the
stockholders.

1 If payment is made in a convertible preferred stock the danger of overvalua¬
tion is, of course, not fully eliminated. For example, Columbia Gas and
Electric Corporation during 1932 paid $1,125 to common stockholders in
5% Convertible Preference Stock (par $100) which was convertible into
common in tho ratio of one share of preference to five shares of common.
The preference stock sold as high as 108 during 1932 and 138 in 1933, or at
equivalents substantially in excess of the earnings of the company on its
oommon stock during those years.

2 For some interesting legal aspects of the power to declare or withhold
dividends see A. A. Berio and G. C. Means, The Modem Corporation and
Private Property , pp. 260-263, New York, 1932.

400

SECURITY ANALYSIS

2. If retention of profits is in any sense a matter of necessity rather than
choice , the stockholders should be advised of this fact, and the amounts
involved should be designated as “reserves” instead of as “surplus profits.”

3. Earnings voluntarily retained in the business should be capitalized in
good part by the periodic issuance of additional stock, with current market
value not exceeding such reinvested earnings. If the additional capital is
subsequently found no longer to be needed in the business, it should be
distributed to the shareholders against the retirement of the stock previously
issued to represent it.

PART V

ANALYSIS OF THE INCOME ACCOUNT
THE EARNINGS FACTOR IN COMMON-STOCK
VALUATION

CHAPTER XXXI

ANALYSIS OF THE INCOME ACCOUNT

In our historical discussion of the theory of investment in
common stocks wc traced the transfer of emphasis from the net
worth of an enterprise to its capitalized earning power. Although
there are sound and compelling reasons behind this development,
it is none the less one that has removed much of the firm ground
that formerly lay—or seemed to lie—beneath investment analysis
and has subjected it to a multiplicity of added hazards. When
an investor was able to take very much the same attitude in
valuing shares of stock as in valuing his own business, he was
dealing with concepts familiar to his individual experience and
matured judgment. Given sufficient information, he was not
likely to go far astray, except perhaps in his estimate of future
earning power. The interrelations of balance sheet and income
statement gave him a double check on intrinsic values, which
corresponded to the formulas of banks or credit agencies in
appraising the eligibility of the enterprise for credit.

Disadvantages of Sole Emphasis on Earning Power—Now
that common-stock values have come to depend exclusively upon
the earnings exhibit, a gulf has been created between the con¬
cepts of private business and the guiding rules of investment.
When the business man lays down his own statement and picks
up the report of a large corporation, he apparently enters a new
and entirely different world of values. For certainly he does
not appraise his own business solely on the basis of its recent
operating results without reference to its financial resources.
When in his capacity as investor or speculator the business man

401

402

SECURITY ANALYSIS

elects to pay no attention whatever to corporate balance sheets,
he is placing himself at a serious disadvantage in several different
respects: In the first place, he is embracing a new set of ideas
that are alien to his everyday business experience. In the
second place, instead of the twofold test of value afforded by
both earnings and assets, he is relying upon a single and therefore
less dependable criterion. In the third place, these earnings
statements on which he relies exclusively are subject to more
rapid and radical changes than those which occur in balance
sheets. Hence an exaggerated degree of instability is introduced
into his concept of stock values. In the fourth place, the earn¬
ings statements are far more subject to misleading presenta¬
tion and mistaken inferences than is the typical balance sheet
when scrutinized by an investor of experience.

Warning against Sole Reliance upon Earnings Exhibit. —In
approaching the analysis of earnings statements we must, there¬
fore, utter an emphatic warning against exclusive preoccupation
with this factor in dealing with investment values. With due
recognition of the greatly restricted importance of the asset
picture, it must nevertheless be asserted that a company's
resources still have some significance and require some attention.
This is particularly true, as will be seen later on, because the
meaning of any income statement cannot properly be understood
except with reference to the balance sheet at the beginning and
the end of the period.

Simplified Statement of Wall Street’s Method of Appraising
Common Stocks. —Viewing the subject from another angle, we
may say that the Wall-Street method of appraising common
stocks has been simplified to the following standard formula:

1. Find out what the stock is earning. (This usually means the earnings
per share as shown in the last report.)

2. Multiply these per-share earnings by some suitable 11 coefficient of
quality” which will reflect:

a. The dividend rate and record.

b. The standing of the company—its size, reputation, financial
position, and prospects.

c. The type of business a cigarette manufacturer will sell at a
higher multiple of earnings than a cigar company).

d. The temper of the general market. (Bull-market multipliers
are larger than those used in bear markets.)

ANALYSIS OF THE INCOME ACCOUNT

403

The foregoing may be summarized in the following formula:

Price ■* current earnings per share X quality coefficient. 1

The result of this procedure is that in most cases the “earnings
per share” have attained a weight in determining value that is
equivalent to the weight of all the other factors taken together.
The truth of this is evident if it be remembered that the “quality
coefficient ” is itself largely determined by the earnings trend ,
which in turn is taken from the stated earnings over a period.

Earnings Not Only Fluctuate but Are Subject to Arbitrary
Determination.—But these earnings per share, on which the
entire edifice of value has come to be built, are not only highly
fluctuating but are subject also in extraordinary degree to
arbitrary determination and manipulation. It will be illuminat¬
ing if we summarize at this point the various devices, legitimate
and otherwise, by which the per-share earnings may at the choice
of those in control be made to appear either larger or smaller.

1. By allocating items to surplus instead of to income, or vice versa .

2. By over- or understating amortization and other reserve charges.

3. By varying the capital structure, as between senior securities and
common stock. (Such moves are decided upon by managements and
ratified by the stockholders as a matter of course.)

4. By the use made of large capital funds not employed in the conduct of
the business.

Significance of the Foregoing to the Analyst.—These intricacies
of corporate accounting and financial policies undoubtedly pro¬
vide a broad field for the activities of the securities analyst.
There are unbounded opportunities for shrewd detective work,
for critical comparisons, for discovering and pointing out a state
of affairs quite different from that indicated by the publicized
“per-share earnings.”

That this work may be of exceeding value cannot be denied.
In a number of cases it will lead to a convincing conclusion that
the market price is far out of line with intrinsic or comparative
worth and hence to profitable action based upon this sound
foundation. But it is necessary to caution the analyst against

1 Where there are no earnings or where the amount is recognized as being
far below “normal,” Wall Street is reluctantly compelled to apply what is
at bottom a more rational method of valuation, i.e. t one ascribing greater
weight to average earning power, working capital, etc. But this is the
exceptional procedure.

404

SECURITY ANALYSIS

overconfidence in the practical utility of his findings. It is
always good to know the truth, but it may not always be wise
to act upon it, particularly in Wall Street. And it must always
be remembered that the truth that the analyst uncovers is
first of all not the whole truth and, secondly, not the immutable
truth. The result of his study is only a more nearly correct
version of the past. His information may have lost its relevance
by the time he acquires it, or in any event by the time the market
place is finally ready to respond to it.

With full allowance for these pitfalls, it goes without saying,
none the less, that security analysis must devote thoroughgoing
study to corporate income accounts. It will aid our exposition
if we classify this study under three headings, viz.:

1. The accounting aspect.

Leading question: What are the true earnings for the period studied?

2. The business aspect.

Leading question: What indications does the earnings record carry as
to the future earning power of the company?

3. The aspect of investment finance.

Leading question: What elements in the earnings exhibit must be taken
into account, and what standards followed, in endeavoring to arrive
at a reasonable valuation of the shares?

CRITICISM AND RESTATEMENT OF THE INCOME ACCOUNT

If an income statement is to be informing in any true sense, it
must at least present a fair and undistorted picture of the year's
operating results. Direct misstatement of the figures in the case
of publicly owned companies is a rare occurrence. The Ivar
Kreuger frauds, revealed in 1932, partook of this character, but
these were quite unique in the baldness as well as in the extent
of the deception. The statements of most important companies
are audited by independent public accountants, and their reports
are reasonably dependable within the rather limited sphere of
accounting accuracy. 1 But from the standpoint of common-

1 In recent years several instances of gross overstatements of earnings and
current assets in audited statements have come to light—notably the case
of McKesson and Robbins Company in 1938. (Interstate Hosiery Mills
and Illinois Zinc Corporation are other examples also uncovered in
1938.) Despite the sensational impression caused by the McKesson and
Robbins scandal, it must be recognized that over a long period of years
only an infinitesimal percentage of publicly owned companies have been
involved in frauds of this character.

ANALYSIS OF THE INCOME ACCOUNT

405

stock analysis these audited statements may require critical
interpretation and adjustment, especially with respect to three
important elements:

1. Nonrecurrent profits and losses.

2. Operations of subsidiaries or affiliates.

3. Reserves.

General Observations on the Income Account.—Accounting
procedure allows considerable leeway to the management in the
method of treating nonrecurrent item* It is a standard and
proper rule that transactions applicable to past years should be
excluded from current income and entered as a charge or credit
direct to the surplus account. Yet there are many kinds of
entries that may technically be considered part of the current
year’s results but that are none the less of a special and non¬
recurrent nature. Accounting rules permit the management to
decide whether to show these operations as part of the income
or to report them as adjustments of surplus . Following are a
number of examples of entries of this type:

1. Profit or loss on sale of fixed assets.

2. Profit or loss on sale of marketable securities.

3. Discount or premium on retirement of capital obligations.

4. Proceeds of life insurance policies.

5. Tax refunds and interest thereon.

6. Gain or loss as result of litigation.

7. Extraordinary write-downs of inventory.

8. Extraordinary write-downs of receivables.

9. Cost of maintaining nonoperating properties.

Wide variations will be found in corporate practice respecting
items such as the foregoing. Under each heading examples may
be given of either inclusion in or exclusion from the income
account. Which is the better accounting procedure in some of
these cases may be a rather controversial question, but, as far as
the analyst is concerned, his object requires that all these items be
segregated from the ordinary operating results of the year. For
what the investor chiefly wants to learn from an annual report is
the indicated earning power under the given set of conditions, i.e.,
what the company might be expected to earn year after year
if the business conditions prevailing during the period were to
continue unchanged. (On the other hand, as we shall point out
later, all these extraordinary items enter properly into the cal-

406

SECURITY ANALYSIS

culation of earning power as actually shown over a period of years
in the past.)

The analyst must endeavor also to adjust the reported earnings
so as to reflect as accurately as possible the company's interest
in results of controlled or affiliated companies. In most cases
consolidated reports are made, so that such adjustments are
unnecessary. But numerous instances have occurred in which
the statements are incomplete or misleading because either:
(1) they fail to reflect any part of the profits or losses of important
subsidiaries or (2) they include as income dividends from sub¬
sidiaries that are substantially less or greater than the current
earnings of the controlled enterprises.

The third aspect of the income account to which the analyst
must give critical attention is the matter of reserves for depre¬
ciation and other amortization, and reserves for future losses
and other contingencies. These reserves are subject in good
part to arbitrary determination by the management. Hence
they may readily be overstated or understated, in which case
the final figure of reported earnings will be correspondingly
distorted. With respect to amortization charges, another and
more subtle element enters which may at times be of considerable
importance, and that is the fact that the deductions from income,
as calculated by the management based on the book cost of the
property, may not properly reflect the amortization that the
individual investor should charge against his own commitment in
the enterprise.

Nonrecurrent Items: Profits or Losses from Sale of Fixed
Assets.—We shall proceed to a more detailed discussion of
these three types of adjustment of the reported income account,
beginning with the subject of nonrecurrent items. 1 Profits or
losses from the sale of fixed assets belong quite obviously to this
category, and they should be excluded from the year's result
in order to gain an idea of the “ indicated earning power" based

1 The Securities Act of 1933 and the Securities Exchange Act of 1934
specifically empower the Commission to prescribe the methods to be
followed in differentiating between recurrent and nonrecurrent items in
the reports of registered companies which must be filed with the S.E.C. and
with the exchanges [Sec. 19(a) of the 1933 act and Sec. 13(b) of the 1934 act].
The initial registration forms (A-l, A-2 and 10) and the annual report form
(10-K) require separation of nonrecurrent profit-and-loss items within the
income account.

ANALYSIS OF THE INCOME ACCOUNT

407

on the assumed continuance of the business conditions existing
then. Approved accounting practice recommends that profit
on sales of capital assets be shown only as a credit to the surplus
account. In numerous instances, however, such profits are
reported by the company as part of its current net income,
creating a distorted picture of the earnings for the period.

Examples: A glaring example of this practice is presented by
the report of the Manhattan Electrical Supply Company for
1926. This showed earnings of $882,000, or $10.25 per share,
which was regarded as a very favorable exhibit. But a subse¬
quent application to list additional shares on the New York
Stock Exchange revealed that out of this $882,000 reported as
earned, no less than $586,700 had been realized through the
sale of the company's battery business. Hence the earnings
from ordinary operations were only $295,300, or about $3.40
per share. The inclusion of this special profit in income was
particularly objectionable because in the very same year the
company had charged to surplus extraordinary losses amounting
to $544,000. Obviously the special losses belonged to the same
category as the special profits, and the two items should have been
grouped together. The effect of including the one in income
and charging the other to surplus was misleading in the highest
degree. Still more discreditable was the failure to make any
clear reference to the profit from the battery sale either in the
income account itself or in the extended remarks that accom¬
panied it in the annual report. 1

During 1931 the United States Steel Corporation reported
“special income" of some $19,300,000, the greater part of which
was due to “profit on sale of fixed property"—understood to be
certain public-utility holdings in Gary, Indiana. This item was
included in the year's earnings and resulted in a final “net
income" of $13,000,000. But since this credit was definitely of
a nonrecurring nature, the analyst would be compelled to
eliminate it from his consideration of the 1931 operating results,
which would accordingly register a loss of $6,300,000 before

1 The president's remarks contained only the following in respect to this
transaction: “After several years of unprofitable experience in the battery
business the directors arranged a sale of same on satisfactory terms." In
1930 a scandal developed by reason of the president's manipulation of this
company's shares on the New York Stock Exchange.

408

SECURITY ANALYSIS

preferred dividends. United States Steel's accounting method
in 1931 is at variance with its previous policy, as shown by its
treatment of the large sums received in the form of income-tax
refunds in the three preceding years. These receipts were not
reported as current income but were credited directly to surplus.

Profits from Sale of Marketable Securities. —Profits realized
by a business corporation from the sale of marketable securities
are also of a special character and must be separated from the
ordinary operating results.

Examples: The report of National Transit Company, a former
Standard Oil subsidiary, for the year 1928 illustrates the dis¬
torting effect due to the inclusion in the income account of
profits from this source. The method of presenting the story
to the stockholders is also open to serious criticism. The
consolidated income account for 1927 and 1928 was stated in
approximately the following terms:

Item

| 1927

| 1928

Operating revenues.

S3,432,000

$3,419,000

Dividends, interest, and miscellanc-

ous income.

403,000

370,000

Total revenues.

$3,895,000

$3,789,000

“ Operating expenses, including depre¬
ciation and profit and loss direct
items” (in 1928 “including profits

from sale of securities”).

3,264,000

2,599,000

Net income.

S 631,000

$1,190,000

(Earned per share).

(SI. 24)

(S2.34)

The increase in the earnings per share appeared quite impres¬
sive. But a study of the detailed figures of the parent company
alone, as submitted to the Interstate Commerce Commission,
would have revealed that $560,000 of the 1928 income was due
to its profits from the sale of securities. This happens to be
almost exactly equal to the increase in consolidated net earnings
over the previous year. Allowing on the one hand for income
tax and other offsets against these special profits but on the
other hand for probable additional profits from the sale of
securities by the manufacturing subsidiary, it seems likely that
all or nearly all of the apparent improvement in earnings for

ANALYSIS OF THE INCOME ACCOUNT

409

1928 was due to nonoperating items. Such gains must clearly
be eliminated from any comparison or calculation of earning
'power. The form of statement resorted to by National Transit,
in which such profits are applied to reduce operating expenses^ is
bizarre to say the least.

The sale by the New York, Chicago and St. Louis Railroad
Company, through a subsidiary, of its holdings of Pere Marquette
stock in 1929 gave rise later to an even more extraordinary form
of bookkeeping manipulation. We shall describe these trans¬
actions in connection with our treatment of items involving
nonconsolidated subsidiaries. During 1931 F. W. Woolworth
Company included in its income a profit of nearly $10,000,000
on the sale of a part interest in its British subsidiary. The
effect of this inclusion was to make the per-share earnings appear
larger than any previous year, when in fact they had experi¬
enced a recession. It is somewhat surprising to note that in
the same year the company charged against surplus an additional
tax accrual of $2,000,000 which seemed to be closely related
to the special profit included in income.

Reduction in the market value of securities should be con¬
sidered as a nonrecurring item in the same way as losses from
the sale of such securities. The same would be true of shrinkage
in the value of foreign exchange. In most cases corporations
charge such write-downs, when made, against surplus. The
General Motors report for 1931 included both such adjustments,
totalling $20,575,000 as deductions from income , but was careful
to designate them as “ extraordinary and nonrecurring losses.”

Methods Used by Investment Trusts in Reporting Sale of Mar¬
ketable Securities. —Investment-trust statements raise special
questions with respect to the treatment of profits or losses realized
from the sale of securities and changes in security values. Prior
to 1930 most of these companies reported profits from the sale
of securities as part of their regular income, but they showed the
appreciation on unsold securities in the form of a memorandum
or footnote to the balance sheet. But when large losses were
taken in 1930 and subsequently, they were shown in most cases
not in the income account but as charges against capital, surplus,
or reserves. The unrealized depreciation was still recorded by
most companies in the form of an explanatory comment on the
balance sheet, which continued to carry the securities owned at

410

SECURITY ANALYSIS

original cost. A minority of investment trusts reduced tho
carrying price of their portfolio to the market by means of charges
against capital and surplus.

It may logically be contended that, since dealing in securities
is an integral part of the investment-trust business, the results
from sales and even the changes in portfolio values should be
regarded as ordinary rather than extraordinary elements in the
year’s report. Certainly a study confined to the interest and
dividend receipts less expenses would prove of negligible value.
If any useful results can be expected from an analysis of invest¬
ment-trust exhibits, such analysis must clearly be based on the
three items: investment income, profits or losses on the sale of
securities and changes in market values. It is equally obvious
that the gain or shrinkage, so computed, in any one year is no
indication whatever of earning power in the recurrent sense. Nor
can an average taken over several years have any significance for
the future unless the results are first compared with some appro¬
priate measure of general market performance. Assuming that
an investment trust has done substantially better than the
relevant “ average,” this is of course a prima facie indication of
capable management. But even here it would be difficult to
distinguish confidently between superior ability and luckier
guesses on the market.

The gist of this critique is twofold: (1) the over-all change in
principal value is the only available measure of investment-trust
performance, but (2) this measure cannot be regarded as an index
of “normal earning power” in any sense analogous to the recorded
earnings of a well-entrenched industrial business. 1

Similar Problem in the Case of Banks and Insurance Companies.
A like problem is involved in analyzing the results shown by
insurance companies and by banks. Public interest in insurance
securities is concentrated largely upon the shares of fire insurance
companies. These enterprises represent a combination of the
insurance business and the investment-trust business. They
have available for investment their capital funds plus substantial
amounts received as premiums paid in advance. Generally

1 See Appendix Note 47, p. 773, for a summary of the findings of the
S.E.C. in its investigation of management investment-trust performance and
for further comment by the authors concerning the record and practices of
management investment trusts.

ANALYSIS OF THE INCOME ACCOUNT

411

speaking, only a small portion of these funds is subject to legal
restrictions as regards investment, and the balance is handled in
much the same way as the resources of the investment trusts.
The underwriting business as such has rarely proved highly profit¬
able. Frequently it shows a deficit, which is offset, however, by
interest and dividend income. The profits or losses shown on
security operations, including changes in their market value, exert
a predominant influence upon the public’s attitude toward fire-
insurance-company stocks. The same has been true of bank
stocks to a smaller, but none the less significant, degree. The
tremendous overspeculation in these issues during the late 1920s
was stimulated largely by the participation of the banks, directly
or through affiliates, in the fabulous profits made in the securities
markets.

Since 1933 banks have been required to divorce themselves
from their affiliates, and their operations in securities other than
government issues have been more carefully supervised and
restricted. But in view of the large portion of their resources
invested in bonds, substantial changes in bond prices are still
likely to exert a pronounced effect upon their reported earnings.

The fact that the operations of financial institutions generally
—such as investment trusts, banks and insurance companies—
must necessarily reflect changes in security values makes their
shares a dangerous medium for widespread public dealings.
Since in these enterprises an increase in security values may be
held to be part of the year’s profits, there is an inevitable tend¬
ency to regard the gains made in good times as part of the “ earn¬
ing power” and to value the shares accordingly. This results
of course in an absurd overvaluation, to be followed by collapse
and a correspondingly excessive depreciation. Such violent
fluctuations are particularly harmful in the case of financial
institutions because they may affect public confidence. It is true
also that rampant speculation (called “investment”) in bank
and insurance-company stocks leads to the ill-advised launching
of new enterprises, to the unwise expansion of old ones and to a
general relaxation of established standards of conservatism and
even of probity.

The securities analyst, in discharging his function of invest¬
ment counsellor, should do his best to discourage the purchase
of stocks of banking and insurance institutions by the ordinary

412

SECURITY ANALYSIS

small investor. Prior to the boom of the 1920s such securities
were owned almost exclusively by those having or command¬
ing large financial experience and matured judgment. These
qualities are needed to avoid the special danger of misjudging
values in this field by reason of the dependence of their reported
earnings upon fluctuations in security prices.

Herein lies also a paradoxical difficulty of the investment-trust
movement. Given a proper technique of management, these
organizations may well prove a logical vehicle for the placing
of small investor's funds. But considered as a marketable
security dealt in by small investors, the investment-trust stock
itself is a dangerously volatile instrument. Apparently this
troublesome factor can be held in check only by educating or by
effectively cautioning the general public on the interpretation of
investment-trust reports. The prospects of accomplishing this
are none too bright.

Profits through Repurchase of Senior Securities at a Dis¬
count. —At times a substantial profit is realized by corporations
through the repurchase of their own senior securities at less than
par value. The inclusion of such gains in current income is
certainly a misleading practice, first, because they are obviously
nonrecurring and, second, because this is at best a questionable
sort of profit, since it is made at the expense of the company's
own security holders.

1Example: A peculiar example of this accounting practice was
furnished as long ago as 1915 by Utah Securities Corporation, a
holding company controlling Utah Power and Light Company.
The following income account illustrates this point:

Year Ended March 31, 1915
Earnings of Utah Securities Corporation includ¬

ing surplus of subsidiaries accruing to it. $ 771,299

Expenses and taxes. 30,288

Net earnings. $ 741,011

Profit on redemption of 6 % notes. 1,309,657

Income from all sources accruing to Utah Securi¬
ties Corporation. $2,050,668

Deduct interest charges on 6 % notes. 1,063,009

Combined net income for the year. $ 987,659

The foregoing income account shows that the chief “earnings"
of Utah Securities were derived from the repurchase of its own

ANALYSIS OF THE INCOME ACCOUNT

413

obligations at a discount. Had it not been for this extraordinary
item the company would have failed to cover its interest charges.

The widespread repurchases of senior securities at a substantial
discount constituted one of the-unique features of the 1931-1933
depression years. It was made possible by the disproportion
that existed between the strong cash positions and the poor
earnings of many enterprises. Because of the latter influence
the senior securities sold at low prices, and because of the
former the issuing companies were able to buy them back in
large amounts. This practice was mot>L in evidence among the
investment trusts.

Examples: The International Securities Corporation of
America, to use an outstanding example, repurchased in the fiscal
year ending November 30, 1932, no less than $12,684,000 of its
5% bonds, representing nearly half of the issue. The average
price paid was about 55, and the operation showed a profit of
about $6,000,000, which served to offset the shrinkage in the value
of the investment portfolio.

In the industrial field we note the report of Armour and Com¬
pany for 1932. This showed net earnings of $1,633,000 but only
after including in income a profit of $5,520,000 on bonds bought
in at a heavy discount. Similarly, more than all of the 1933 net
of Goodrich Rubber, United Drug, Bush Terminal Building
Company and others was ascribable to this nonrecurring source.
A like condition was disclosed in the report of United Cigar-
Whelan Stores for the first half of 1938. 1 (Observe, on the other
hand, that some companies, e.g. f Gulf States Steel Corporation in
1933, have followed the better practice of crediting this profit
direct to surplus.)

A contrary result appears when senior securities are retired
at a cost exceeding the face or stated value. When this premium
involves a large amount, it is always charged against surplus
and not against current income.

Examples: As prominent illustrations of this practice, we cite
the charge of $40,600,000 against surplus made by United States
Steel Corporation in 1929, in connection with the retirement at
110 of $307,000,000 of its own and subsidiaries' bonds, also the
charge of $9,600,000 made against surplus in 1927 by Goodyear
Tire and Rubber Company, growing out of the retirement at a

1 The report for the full year 1938 credited this profit to surplus.

414

SECURITY ANALYSIS

premium of various bond and preferred-stock issues and their
replacement by new securities bearing lower coupon and dividend
rates. From the analyst’s standpoint, either profit or expense
in such special transactions involving the company’s own
securities should be regarded as nonrecurring and excluded from
the operating results in studying a single year’s performance.

Report of American Machine and Metals, Inc., for 1931 and 1932

Item

1932

1931

Income account:

Net before depreciation and interest..

Loss $ 136,886 :

Profit $101,534

Add profit on bonds repurchased. . .

174,278

270,701

Profit, including bonds repurchased.

37,393

372,236

Depreciation.

87,918

184,562

Bond interest.

119,273

140,658

Final net profit or loss.

Loss 169,798

Projit 47,015

Charges against capital, capital surplus

and earned surplus:

Deferred moving expense and mine

development.

111,014

Provision for losses on:

Doubtful notes, interest thereon,

and claims.

600,000

Inventories.

385,000

Investments.

54,999

Liquidation of subsidiary.

39,298

Depletion of ore reserves.

28,406

32,515

Write-down of fixed assets (net).

557,578

Reduction of ore reserves and mineral

rights.

681,742

Federal tax refund, etc.

cr. 7,198

cr. 12,269

Total charges not shown in income

account.

$2,450,839

$ 20,246

Result shown in income account.

dr. 169,798

cr. 47,015

Received from sale of additional stock..

cr. 44,000

Combined change in capital and surplus

dr. $2, 676,637

cr. $ 26,769

A Comprehensive Example .—American Machine and Metals,
Inc. (successor to Manhattan Electrical Supply Company men¬
tioned earlier in this chapter), included in its current income
for 1932 a profit realized from the repurchase of its own bonds

ANALYSIS OF THE INCOME ACCOUNT

415

at a discount. Because the reports for 1931 and 1932 illustrate
to an unusual degree the arbitrary nature of much corporate
accounting, we reproduce herewith in full the income account
and the appended capital and surplus adjustments.

We find again in 1932, as in 1926, the highly objectionable
practice of including extraordinary profits in income while
charging special losses to surplus. It docs not make much
difference that in the later year the nature of the special profit—
gain through repurchase of bonds at less than par—is disclosed
in the report. Stockholders and stock buyers for the most part
pay attention only to the final figure of earnings per share, as
presented by the company; nor are they likely to inquire care¬
fully into the manner in which it is determined. The significance
of some of the charges made by this company against surplus
in 1932 will be taken up later under the appropriate headings.

Other Nonrecurrent Items. —The remaining group of non¬
recurrent profit items is not important enough to merit detailed
discussion. In most cases it is of minor consequence whether
they appear as part of the year’s earnings or arc credited to
surplus where they properly belong.

1Examples: Gimbcl Brothers included the sum of $167,660,
proceeds of life insurance policies, in income for 1938, designating
it as a “nontrading item.” On the other hand, United Mer¬
chants and Manufacturers, receiving a similar payment of
$1,579,000 in its 1938 fiscal year, more soundly credited it to
surplus—although it had sustained a large loss from operations.

Bendix Aviation Corporation reported as income for the year
1929 the sum of $901,282 received in settlement of a patent suit,
and again in 1931 it included in current earnings an amount
$242,656 paid to it as back royalties collected through litigation.
The 1932 earnings of Gulf Oil Corporation included the sum of
$5,512,000 representing the value of oil previously in litigation.
By means of this item, designated as nonrecurrent, it was able to
turn a loss of $2,768,000 into a profit of $2,743,000. Although
tax refunds are regularly shown as credits to surplus only, the
accumulated interest received thereon sometimes appears as part
of the income account, e,g. } $2,000,000 reported by E. I. du Pont
de Nemours and Company in 1926 and an unstated but appar¬
ently much larger sum included in the earnings of United States
Steel for 1930.

CHAPTER XXXII

EXTRAORDINARY LOSSES AND OTHER SPECIAL
ITEMS IN THE INCOME ACCOUNT

The question of nonrecurrent losses is likely to create peculiar
difficulties in the analysis of income accounts. To what extent
should write-downs of inventories and receivables be regarded
as extraordinary deductions not fairly chargeable against the
year’s operating results? In the disastrous year 1932 such
charge-offs were made by nearly every business. The account¬
ing methods used showed wide divergences, but the majority
of companies spared their income accounts as much as possible
and subtracted these losses from surplus. On the other hand the
milder inventory losses of the 1937-1938 recession were almost
universally charged into the earnings statement.

Inventory losses are directly related to the conduct of the
business and are, therefore, by no means extraordinary in their
general character. The collapse of inventory values in 1931-
1932 might be considered extraordinary in its extent, in the same
way as the business results as a whole were exceptional. It
follows from this reasoning that if the 1931-1932 results are taken
into account at all, e.g., in computing a long-term average, all
losses on inventories and receivables must be considered part of
the operating deficit of those years even though charged to sur¬
plus. In Chap. XXXYII we shall consider the role of extra¬
ordinary years in determining the average earning power.

Manufactured Earnings. —An examination of the wholesale
charges made against surplus in 1932 by American Machine and
Metals, detailed on page 414, suggests the possibility that
excessive provision for losses may have been made in that year
with the intention of benefiting future income accounts. If the
receivables and inventories were written down to an unduly
low figure on December 31, 1932, this artificially low “cost
price” would give rise to a correspondingly inflated profit in the

410

ANALYSIS OF THE INCOME ACCOUNT

417

following years. This point may be made clear by the use of
hypothetical figures as follows:

Assume fair value of inventory and receivables on

Dec. 31, 1932 to be.:. $2,000,000

Assume profit for 1933 based on such fair value. . 200,000

But assume that, by special and excessive charges
to surplus, the inventory and receivables had

been written down to. 1, COO, 000

Then the amounts realized therefrom will show a
correspondingly greater profit for 1933, which
might mean reported earnings for 1933 of. .. . 600,000

This would be three times the proper figure.

The foregoing example illustrates a whole set of practices that
constitute perhaps the most vicious type of accounting manipu¬
lation. They consist, in brief, of taking sums out of surplus
(or even capital) and then reporting these same sums as income.
The charge to surplus goes unnoticed; the credit to income may
have a determining influence upon the market price of the
securities of the company. 1 We shall later point out that the
“conservative” writing down of the property account has pre¬
cisely this result, in that it permits a decreased depreciation
charge and hence an increase in the apparent earnings. The
dangers inherent in accounting methods of this sort are the more
serious because they are so little realized by the public, so difficult
to detect even by the expert analyst and so impervious to legis¬
lative or stock-exchange correction.

The basing of common-stock values on reported per-share
earnings has made it much easier for managements to exercise
an arbitrary and unwholesome control over the price level of
their shares. Whereas it should be emphasized that the over¬
whelming majority of managements are honest, it must be

1 The United States Industrial Alcohol Company reports for 1932 and
subsequent years reflect a situation somewhat similar to that here suggested.
This company departed from its usual practice in 1932 by setting up a
reserve for $1,500,000 out of surplus to reduce molasses inventory to esti¬
mated current market value. (Previously this item had regularly been
carried at cost.) Later reports state that earnings for 1933, 1934 and 1935
had benefited by this reserve to the extent of $772,000, $677,000 and
$51,000 respectively. Significantly, income tax for 1934 was based on
$677,000 less than the reported profit. (See pp. 619-620 for a broad sum¬
mary of the effect of this company's accounting methods on its reported per-
share earnings for the years 1929-1938).

418

SECURITY ANALYSIS

emphasized also that loose or “purposive” accounting is a
highly contagious disease.

Reserves for Inventory Losses. —The accounting for inventory
losses is frequently complicated by the use of reserves set up
before the loss is actually realized. These reserves are usually
created by a charge to surplus, on the theory that it is a function
of the surplus account to act as a sort of contingency reserve to
absorb unusual future losses. If later the inventory shrinkage
actually takes place, it is naturally charged against the reserve
already created to meet it. The result is that in no year does the
income account reflect the inventory loss, although it is just as
much a hazard of operations as a decline in selling prices. When
a company charges inventory losses to surplus—whether directly
or through the intermediary of a reserve device—the analyst
must take this practice carefully into account, especially in
comparing the published results with those of other compa¬
nies. A good illustration of this rule is afforded by a com¬
parison of the reports submitted by United States Rubber
Company and by Goodyear Tire and Rubber Company for the
years 1925-1927, during which time rubber prices were subject to
wide fluctuations.

In these three years Goodyear charged against earnings a total
of $11,500,000 as reserves against decline of raw-material prices.
Of this amount one-half was used to absorb actual losses sus¬
tained and the other half was carried forward into 1928 (and
eventually used up in 1930).

United States Rubber during this period charged a total of
$20,446,000 for inventory reserves and write-downs, all of which
was absorbed by actual losses taken. But the form of annual
statement, as submitted to the stockholders, excluded these
deductions from income and made them appear as special adjust¬
ments of surplus. (In 1927, moreover, the inventory loss of
$8,910,000 was apparently offset by a special credit of $8,000,000
from the transfer of past earnings of the crude-rubber producing
subsidiary.)

The result of these divergent bases of reporting annual income
was that the per-share earnings of the two companies, as com¬
piled by the statistical manuals, made an entirely misleading
comparative exhibit. The following per-share earnings are taken
from Poor’* Manual for 1928:

ANALYSIS OF THE INCOME ACCOUNT

419

Year

U.S. Rubber

Goodyear

1925

$14.92

$9.45

1926

10.54

3.79

1927

1.26

9.02

3-year average.

$ 8.91

$7.42

For proper comparative purposes the statements must mani¬
festly be considered on an identical baris. or as close thereto as
possible. Such a comparison might be made by three possible
methods, viz.:

1. As reported by United States Rubber, i.e., excluding inventory reserves
and losses from the current income account.

2. As reported by Goodyear, i.e., reducing the earnings of the period of
high prices for crude rubber by a reserve for future losses and using this
reserve to absorb the later shrinkage.

3. Eliminating such reserves, as an arbitrary effort of the management to
level out the earnings. On this basis the inventory losses would be deducted
from the results of the year in which they were actually sustained. (The
Standard Statistics Company's analysis of Goodyear includes a revision of
the reported earnings in conformity with this approach.)

We have then, for comparative purposes, three statements of
the per-share earnings for the period:

Year

1. Omitting adjust¬

ments of inventory

2. Allowing for inven¬
tory adjustments, as i
made by the com¬
panies

3. Excluding reserve*

and charging losses to
the year in which de¬
cline occurred

U.S. Rubber

Goodyear

U.S. Rubber

| Goodyear

U.S. Rubber

Goodyear

1925

$14.92

$18.43

$11.21

$9.45

$14.92

$18.48

1926

10.54

3.79

0.00

3.79

14.71(d)

t. 58(d)

1927

1.26*

13.24

9.73(d)*

9.02

1.20*

13.24

3-year average

$ 8.91

$12.17

$ 0.49

$7.42

$ 0.49

$ 9.73

* Excluding credit for profits made prior to 1920 by United States Rubber Plantations,
Ino.

The range of market prices for the two common issues during
this period suggests that the accounting methods followed by

420

SECURITY ANALYSIS

United States Rubber served rather effectively to obscure the
unsatisfactory nature of its results for these years.

Year

U.S. Rubber common

Goodyear common

High

Low

High

Low

1925

1926

1927

! 37 |

Average of highs and lows..

More recently United States Rubber has followed the Goodyear
practice of taking out of the earnings of prosperous years a reserve
for future inventory shrinkage. As a result of this policy, the
company somewhat understated its earnings for 1935 and 1936
but overstated them for 1937.

A More Recent Contrast .—The packing industry supplies us
with a more extreme divergence in the method used by two
companies to handle the matter of probable future inventory
losses.

Wilson and Company set up a reserve of $750,000 prior to the
beginning of its 1934 fiscal year, for “ Fluctuation in Inventory
Valuation.” This was taken partly from surplus and partly
from income. In 1934 it reduced its opening inventory by this
reserve, thus increasing the year’s reported profit by $750,000.
The S.E.C., however, required it to amend its registration state¬
ment so as to credit this amount to surplus and not to income.

On the other hand, Swift and Company reduced its reported
earnings in the fiscal years 1933-1935 by $16,767,000, which was
set up as a reserve for future inventory decline. In 1938 the
expected decline occurred; but instead of drawing on this reserve
to spare the income account, the company charged the full loss
against the year’s operations and then transferred $11,000,000
of the reserve directly to surplus. In this exceptional case the
net income for the six-year period 1933-1938 was understated,
since amounts were actually taken out of income and turned over
to surplus . 1

1 Standard Statistics has restated the Swift annual reports by listing the
1938-1935 deductions for inventory declines as charges to surplus.

ANALYSIS OF THE INCOME ACCOUNT

421

Other Elements in Inventory Accounting.—The student of
corporate reports must familiarize himself with two permissible
variations from the usual accounting practice in handling inven¬
tories. As is well known, ther standard procedure consists of
taking inventory at the close of the year at the lower of cost or
market. The “cost of goods sold” is then found by adding
purchases to the opening inventory and subtracting the closing
inventory, valued as described.

Last — In, First — Out .—The first variation from this method
consists of taking as the cost of goods sold the actual amount paid
for the most recently acquired lots. The theory behind this
method is that a merchant's selling price is related mainly to the
current replacement price or the recent cost of the article sold.
The point is of importance only when there are substantial
changes in unit values from year to year; it cannot affect the
aggregate reported profits over a long period but only the division
of results from one year to another; it may be useful in reducing
income tax by avoiding alternations of loss and profit due to
inventory fluctuations. 1

The Normal-stock or Basic-stock Inventory Method .—A more
radical method of minimizing fluctuations due to inventory
values has been followed by a considerable number of companies
for some years past. This method is based on the theory that the
company must regularly carry a certain physical stock of mate¬
rials and that there is no more reason to vary the value of this
“normal stock" from year to year—because of market changes—
than there would be to vary the value of the manufacturing
plant as the price index rises or falls and to reflect this change in
the year's operations. In order to permit the base inventory to be
carried at an unchanging figure, the practice is to mark it down
to a very low unit price level—so low that it should never be
necessary to reduce it further to get it down to current market.

As long ago as 1913 National Lead Company applied this
method to the three principal constituents of its inventory, viz.,
lead, tin and antimony. The method was subsequently adopted

1 Corporations were first permitted to use this so-called “last-in, first-out”
method by the terms of the Revenue Acts of 1938 and 1939, applying to
1939 and subsequent years. A hypothetical example to illustrate the differ¬
ence between the two inventory methods is given in Appendix Note 48,
p. 775.

422

SECURITY ANALYSIS

also by American Smelting and Refining Company and American
Metals Company. Some of the New England cotton mills had
followed a like policy, prior to the collapse in the cotton market
in 1930, by carrying their raw cotton and work in process at very
low base prices. In 1936 the Plymouth Cordage Company
adopted the normal-stock inventory method, after following a
somewhat similar policy in 1933-1935; and for purpose of con¬
crete illustration we supply the relevant data for this company,
covering the years 1930-1939, in Appendix Note 49, page 776.

Idle-plant Expense.—The cost of carrying nonoperating
properties is almost always charged against income. Many
statements for 1932 earmarked substantial deductions under
this heading.

Examples: Youngstown Sheet and Tube Company reported a
charge of $2,759,000 for “Maintenance Expense, Insurance and
Taxes of Plants, Mines, and Other Properties that were Idle. ,,
Stewart Warner Corporation followed the exceptional policy
of charging against surplus in 1932, instead of income, the sum
of $309,000 for “ Depreciation of Plant Facilities not used in
current year's production." The 1938 report of Botany Worsted
Mills contained a charge against income of $166,732, pictur¬
esquely termed “cost of idleness."

The analyst may properly consider idle-plant expense as
belonging to a somewhat different category from ordinary
charges against income. In theory, at least, these expenses
should be of a temporary and therefore nonrecurring type.
Presumably the management can terminate these losses at any
time by disposing of or abandoning the property. If, for the
time being, the company elects to spend money to carry these
assets along in the expectation that future value will justify
the outlay, it does not seem logical to consider these assets as
equivalent to a permanent liability, z.e., as a permanent drag
upon the company's earning power, which makes the stock
worth considerably less than it would be if these “assets" did
not exist.

Example: The practical implications of this point are illustrated
by the case of New York Transit Company, a carrier of oil by
pipe line. In 1926, owing to new competitive conditions, it
lost all the business formerly carried by its principal line, which
thereupon became “idle plant." The depreciation, taxes and

ANALYSIS OF THE INCOME ACCOUNT

423

other expenses of this property were so heavy as to absorb the
earnings of the company’s other profitable assets (consisting of a
smaller pipe line and high-grade-bond investments). This
created an apparent net loss and caused the dividend to be passed.
The price of the stock accordingly declined to a figure far less
than the company’s holdings of cash and marketable securities
alone. In this uncritical appraisal by the stock market, the
idle asset was considered equivalent to a serious and permanent
liability.

In 1928, however, the directors detei mined to put an end to
these heavy carrying charges and succeeded in selling the unused
pipe line for a substantial sum of money. Thereafter, the stock¬
holders received special cash distributions aggregating $72 per
share (nearly twice the average market price for 1926 and 1927),
and they still retained ownership of a profitable business which
resumed regular dividends. Even if no money had been realized
from the idle property, its mere abandonment would have led to
a considerable increase in the value of the shares.

This is an impressive, if somewhat extreme, example of the
practical utility of security analysis in detecting discrepancies
between intrinsic value and market price. It is customary to
refer with great respect to the “bloodless verdict of the market
place,” as though it represented invariably the composite
judgment of countless shrewd, informed and calculating minds.
Very frequently, however, these appraisals are based on mob
psychology, on faulty reasoning, and on the most superficial
examination of inadequate information. The analyst, on his
side, is usually unable to apply his technique effectively to
correcting or taking advantage of these popular errors, for the
reason that surrounding conditions change so rapidly that his
own conclusions may become inapplicable before he can profit
by them. But in the exceptional case, as illustrated by our last
example, the facts and the logic of the case may be sharply
enough defined to warrant a high degree of confidence in the
practical value of his analysis.

Deferred Charges.—A business sometimes incurs expenses
that may fairly be considered as applicable to a number of
years following rather than to the single 12-month period in
which the outlay was made. Under this heading might be
included the following:

424

SECURITY ANALYSIS

Organization expense (legal fees, etc.).

Moving expenses.

Development expenses (for new products or processes, also for opening
up a mine, etc.).

Discount on obligations sold.

Under approved accounting methods such costs are spread
over an appropriate period of years. The amount involved is
entered upon the balance sheet as a Deferred Charge, which is
written off by annual charges against earnings. In the case of
bond-discount the period is fixed by the life of the issue;
mine development expenses are similarly prorated on the basis
of the tonnage mined. For most other items the number of
years must be arbitrarily taken, five years being a customary
figure.

In order to relieve the reported earnings of these annual
deductions it has become common practice to write off such
expense applicable to future years by a single charge against
surplus. In theory this practice is improper, because it results
in the understatement of operating expenses for a succeeding
period of years and hence in the exaggeration of the net income.
If, to take a simple example, the president's salary were paid
for ten years in advance and the entire outlay charged against
surplus as a “special expense," it is clear that the profits of the
ensuing period would thereby be overstated. 1 There is the
danger also that expenses of a character frequently repeated,
e.g. y advertising campaigns, or cost of developing new automobile
models, might be omitted from the income account by designating
them as deferred charges and then writing them off against
surplus. 2

Ordinarily the amounts involved in such accounting trans¬
actions are not large enough to warrant the analyst's making
an issue of them. Security analysis is a severely practical
activity, and it must not linger over matters that are not likely

1 See Appendix Note 50, p. 777, for details of accounting methods fol¬
lowed by Interstate Department Stores in 1934-1936, which resembled
somewhat the hypothetical case given above.

* A similar objection lies against the practice of charging against surplus
the loss incurred in closing chain-store units. Example: The charge of
$326,000 made by F. G. Shattuck Company for this purpose in 1935. This
would seem to be a recurrent expense of chain-store enterprises, which
frequently add and close down units.

ANALYSIS OF THE INCOME ACCOUNT

425

to affect the ultimate judgment. At times, however, these
items may assume appreciable importance.

Examples: The Kraft Cheese Company for example, during
some years prior to 1927 carried a substantial part of its adver¬
tising outlays as a deferred charge to be absorbed in the oper¬
ations of subsequent years. In 1926 it spent about $1,000,000
for advertising and charged only one-half of this amount against
current income. But in the same year the balance of this
expenditure was deducted from surplus, and furthermore an
additional $480,000 was similarly written off against surplus to
cancel the balance carried forward from prior years as a deferred
charge. By this means the company was able to report to its
stockholders the sum of $1,071,000 as earned for 1926. But
when in the following year it applied to list additional shares, it
found it necessary to adopt a less questionable basis of reporting
its income to the New York Stock Exchange, so that its profit
for 1926 was restated to read $461,296, instead of $1,071,000.

The 1932 report of International Telephone and Telegraph
Company showed various charges against surplus aggregating
$35,817,000, which included the following: “ Write-off of certain
deferred charges that have today no tangible value although
originally set up to be amortized over a period of years in accord¬
ance with accepted accounting principles, $4,655,696.”

Hudson Motor Car Company charged against surplus instead
of income the following items (among others) during 1930-1931.
1930. Special adjustment of tools and materials due to devel¬

opment of new models. $2,266,000

1931. Reserve for special tools. 2,000,000

Rearrangement of plant equipment . 633,000

Special advertising. 1,400,000

In 1933 Hecker Products (then called Gold Dust Corporation)
appropriated out of surplus the sum of $2,000,000 as a reserve
for the “net cost of introduction and exploitation of new prod¬
ucts.” About three-quarters of this amount was expended in
years 1933-1936, and the balance then transferred to “Gen¬
eral and Contingency Reserves.”

The effect of these accounting practices is to relieve the
reported earnings of expenditures that most companies charge
currently thereagainst, and that in any event should be charged
against earnings in installments over a short period of years.

426

SECURITY ANALYSIS

Amortization of Bond Discount. —Bonds are usually floated
by corporations at a price to net the treasury less than par.
The discount suffered is part of the cost of borrowing the money,
i.e., part of the interest burden, and it should be amortized over
the life of the bond issue by an annual charge against earnings,
included with the statement of interest paid. It was formerly
considered “conservative” to write off such bond discounts by a
single charge against surplus, in order not to show so intangible
an item among the assets on the balance sheet. More recently
these write-offs against surplus have become popular for the
opposite reason, viz., to eliminate future annual deductions from
earnings and in that way to make the shares more “valuable.”

Example: Associated Gas and Electric Company charged
against surplus in 1932 the sum of $5,892,000 for “debt discount
and expense” written off.

This practice has aroused considerable criticism in recent years
both from the New York Stock Exchange and from the S.E.C.
As a result of these objections a number of companies have
reversed their previous charge to surplus and arc again charging
amortization of bond discounts annually against earnings. 1

1 See the changed accounting practice of Northern States Power Company
(Minnesota) following a controversy over this point in connection with the
registration of a bond issue in 1934. (The total amount involved here was
over $8,000,000.) It is noteworthy, also, that even on called bonds companies
have been required to carry forward the unamortized discount to be written
off by an annual charge against earnings during the life of the refunding issue.
(Sec the report of Columbia Gas and Electric Company for 1936, p. 17.)

Some of the bond refundings in recent years seem to have involved a
surprisingly small net saving of interest when the premium paid to retire
the old issue is taken into account. Perhaps an explanation of some of
these operations lies in the fact that (1) the company has been able to charge
both the premium paid and the balance of the original discount against
surplus, thus relieving future earnings of this very real burden; and (2) both
these items have been chargeable to profits subject to income tax , thus
reducing this tax substantially and increasing the apparent profits for
the year.

CHAPTER XXXIII

MISLEADING ARTIFICES IN THE INCOME ACCOUNT.
EARNINGS OF SUBSIDIARIES

Flagrant Example of Padded Income Account. —On compara¬
tively rare occasions, managements resort to padding their
income account by including items in earnings that have no
real existence. Perhaps the most flagrant instance of this kind
that has come to our knowledge occurred in the 1929-1930
reports of Park and Tilford, Inc., an enterprise with shares
listed on the New York Stock Exchange. For these years the
company reported net income as follows:

1929— $1,001,130 « $4.72 per share.

1930— 124,563 = 0.57 per share.

An examination of the balance sheets discloses that during
these two years the item of Good-will and Trade-marks was
written up successively from $1,000,000 to $1,600,000 and then
to $2,000,000, and these increases deducted from the expenses
for the period. The extraordinary character of the bookkeeping
employed will be apparent from a study of the condensed balance
sheets as of three dates, shown on page 428.

These figures show a reduction of $1,600,000 in net current
assets in 15 months, or $1,000,000 more than the cash dividends
paid. This shrinkage was concealed by a $1,000,000 write-up
of Good-will and Trade-marks. No statement relating to these
amazing entries was vouchsafed to the stockholders in the annual
reports or to the New York Stock Exchange in subsequent
listing applications. In answer to an individual inquiry, how¬
ever, the company stated that these additions to Good-will
and Trade-marks represented expenditures for advertising and
other sales efforts to develop the business of Tintex Company,
Inc., a subsidiary. 1

1 In the 1930 report the wording in the balance sheet was changed from
u Good-will and Trade-marks” to ,a Tintex Good-will and Trade-marks.”
In 1939 the Good-will item was written off, and the $1,000,000 write-up
of 1929-1930 deducted from earned surplus.

427

ANALYSIS OF THE INCOME ACCOUNT

429

The charging of current advertising expense to the good-will
account is inadmissible under all canons of sound accounting.
To do so without any disclosure to the stockholders is still more
discreditable. It is difficult to believe, moreover, that the sum
of $600,000 could have been expended for this purpose by Park
and Tilford in the three months between September 30 and
December 31, 1929. The entry appears therefore to have
included a recrediting to current income of expenditures made
in a previous period , and to that extent the results for the fourth
quarter of 1929 may have been flagrantly distorted. Needless
to say, no accountants* certificate accompanied the annual
statements of this enterprise.

Balance-sheet and Income-tax Checks upon the Published
Earnings Statements. —The Park and Tilford case illustrates the
necessity of relating an analysis of income accounts to an exami¬
nation of the appurtenant balance sheets. This is a point that
cannot be stressed too strongly, in view of Wall Streets naive
acceptance of reported income and reported earnings per share.
Our example suggests also a further check upon the reliability of
the published earnings statements, viz., by the amount of the
federal income tax accrued. The taxable profit can be calculated
fairly readily from the income-tax accrual, and this profit com¬
pared in turn with the earnings reported to stockholders. The
two figures should not necessarily be the same, since the intricacies
of the tax laws may give rise to a number of divergences. 1 We
do not suggest that any effort be made to reconcile the amounts
absolutely but only that very wide differences be noted and made
the subject of further inquiry.

The Park and Tilford figures analyzed from this viewpoint
supply the suggestive results as shown in the table on page 430.

The close correspondence of the tax accrual with the reported
income during the earlier period makes the later discrepancy
appear the more striking. These figures eloquently cast suspi¬
cion upon the truthfulness of the reports made to the stockholders
during 1927-1929, at which time considerable manipulation was
apparently going on in the shares.

This and other examples discussed herein point strongly to
the need for independent audits of corporate statements by
certified public accountants. It may be suggested also that

1 See Appendix Note 51, p. 778, for a brief r&um6 of these divergences.

430

SECURITY ANALYSIS

annual reports should include a detailed reconcilement of the
net earnings reported to the shareholders with the net income
upon which the federal tax is paid. In our opinion a good deal
of the information relative to minor matters that appears in
registration statements and prospectuses might be dispensed with
to general advantage; but if, in lieu thereof, the S.E.C. were to
require such a reconcilement, the cause of security analysis would
be greatly advanced.

Period

Federal
income tax
accrued

Rate of tax,
per cent

Net income before
federal tax

A. As indi¬
cated by the
tax accrued

B. As re¬
ported to the
stockholders

5 mo. to Dec. 1925

$36,881

■■

$283,000

$ 297,000

1920

66,624

493,000

533,000

1927

51,319

■Em

380,000

792,000

1928

79,852

665,000

1,315,000

1929

81,623*

■■

744,000

1,076,000

♦ Including $0,623 additional paid in 1931.

Another Extraordinary Case of Manipulated Accounting.—An

accounting vagary fully as extraordinary as that of Park and
Tilford, though exercising a smaller influence on the reported
earnings, was indulged in by United Cigar Stores Company of
America, from 1924-1927. The “ theory ” behind the entries
was explained by the company for the first time in May 1927 in
a listing application that contained the following paragraphs: 1

The Company owns several hundred long-term leaseholds on business
buildings in the principal cities of the United States, which up until May,
1924, were not set up on the books. Accordingly, at that time they were
appraised by the Company and Messrs. F. W. Lafrentz and Company,
certified public accountants of New York City, in excess of $20,000,000.

The Board of Directors have, since that time, authorized every three
months the setting up among the assets of the Company a portion of this
valuation and the capitalization thereof, in the form of dividends, payable

1 See application to list 0% Cumulative Preferred Stock of United Cigar
Stores Company of America on the New York Stock Exchange, dated May
18, 1927 (Application #A-7552).

ANALYSIS OF THE INCOME ACCOUNT 431

in Common Stock at par on the Common Stock on the quarterly basis of
1K% on the Common Stock issued and outstanding.

The entire capital surplus created in this manner has been absorbed by
the issuance of Common Stock at par for an equal amount and accordingly
is not a part of the existing surplus of the Company. No cash dividends
have been declared out of such capital surplus so created.

The present estimated value of such leaseholds, using the same basis of
appraisal as in 1924, is more than twice the present value shown on the books
of the Company.

The effect of the inclusion of "Appreciation of Leaseholds”
in earnings is shown herewith:

Year

Net earnings
as reported

Earned per
share of

common

($25-par

basis)

Market

range

($25-par

basis)

Amount of
“ Leasehold
Appreciation ”
included in
earnings

Earned per
share of

common ex¬
cluding lease
appreciation

1924

$6,697,000

$4.69

64-43

$1,248,000

$3.77

1925

8,813,000

5.95

116-60

1,295,000*

5.05

1926

9,855,000

6.02

110-83

2,302,000

3.81

1927

9,952,000t

4.63

100-81

2,437,000

3.43

* The 5% stock dividend paid m 1925 amounted to 81,737,770. There is an unexplained
difference between the two figures, which in the other years are identical,
t Excluding refund of federal taxes of 8229,017 applicable to prior years.

In passing judgment on the inclusion of leasehold appreciation
in the current earnings of United Cigar Stores, a number of
considerations might well be borne in mind.

1. Leaseholds are essentially as much a liability as they are an asset.
They arc an obligation to pay rent for premises occupied. Ironically
enough, these very leaseholds of United Cigar Stores eventually plunged it
into bankruptcy.

2. Assuming leaseholds may acquire a capital value to the occupant,
such value is highly intangible, and it is contrary to accounting principles
to mark up above actual cost the value of such intangibles in a balance
sheet.

3. If the value of any capital asset is to be marked up, such enhancement
must be credited to Capital Surplus. By no stretch of the imagination can
it be considered as income .

4. The $20,000,000 appreciation of the United Cigar Stores leases took
place prior to May 1924, but it was treated as income in subsequent years .
There was thus no connection between the $2,437,000 appreciation included
in the profits of 1927 and the operations or developments of that year.

432

SECURITY ANALYSIS

6. If the leaseholds had really increased in value, the effect should be
visible in larger earnings realized from these favorable locations. Any
other recognition given this enhancement would mean counting the same
value twice. In fact, however, allowing for extensions of the business
financed by additional capitalization, the per-share earnings of United
Cigar Stores showed no advancing trend.

6. Whatever value is given to leaseholds must be amortized over the
life of the lease. If the United Cigar Stores investors were paying a high
price for the shares because of earnings produced by these valuable leases,
then they should deduct from earnings an allowance to write off this capital
value by the time it disappears through the expiration of the leases. 1 The
United Cigar Stores Company continued to amortize its leaseholds on
the basis of original cost t which apparently was practically nothing.

The surprising truth of the matter, therefore, is that the effect of the
appreciation of leasehold values—if it had occurred—should have been to
reduce the subsequent operating profits by an increased amortization charge.

7. The padding of the United Cigar Stores income for 1924-1927 was
made the more reprehensible by the failure to reveal the facts clearly in the
annual reports to shareholders. 2 Disclosure of the essential facts to the
New York Stock Exchange was made nearly three years after the practice
was initiated. It may have been compelled by legal considerations growing
out of the sale to the public at that time of a new issue of preferred stock,
underwritten by large financial institutions. The following year the policy
of including leasehold appreciation in earnings was discontinued.

These accounting maneuvers of United Cigar Stores may be
fairly described, therefore, as the unexplained inclusion in current
earnings of an imaginary appreciation of an intangible asset—the
asset being in reality a liability , the enhancement being related
to a previous period and the proper effect of the appreciation, if
it had occurred, being to reduce the subsequent realized earnings
by virtue of higher amortization charges.

The federal-income-tax check, described in the Park and Til-
ford example, will also give interesting results if applied to United
Cigar Stores as shown in the table on p. 433.

Moral Drawn from Foregoing Examples. —A moral of con¬
siderable practical utility may be drawn from the United Cigar
Stores example. When an enterprise pursues questionable

1 This subject is treated fully in a succeeding chapter.

* The reports stated the “Net Profit for the year, including Enhancement
of Leasehold Values ,, (giving amount of the latter), but no indication was
afforded that this enhancement was arbitrarily computed and had taken
place in previous years.

ANALYSIS OF THE INCOME ACCOUNT

433

accounting policies, all its securities must be shunned by the
investor, no matter how safe or attractive some of them may
appear. This is well illustrated by United Cigar Stores Preferred,
which made an exceedingly impressive statistical showing for
many successive years but later narrowly escaped complete
extinction. Investors confronted with the strange bookkeeping
detailed above might have reasoned that the issue was still
perfectly sound, because, when the overstatement of earnings was
corrected, the margin of safety remained more than ample.
Such reasoning is fallacious. You cannot make a quantitative
deduction to allow for an unscrupulous management; the only
way to deal with such situations is to avoid them.

Year

Federal
tax reserve

Income before tax

A. Indicated by
tax reserve

D. Reported to
stockholders

C. Reported to
stockholders less
leasehold
appreciation

1924

$700,000

$5,600,000

$ 7,397,000

$6,149,000

1925

825,000

6,340,000

9,638,000

8,343,000

1926

900,000

6,667,000

10,755,000

8,453,000

1927

900,000

6,667,000

10,852,000*

8,415,000*

1928

700,000

5,833,000

9,053,000

1929

13,000

118,000

3,132,000t

3,132,000f

1930

none

1,552,000

* Eliminating tax refund of $229,000 evidently applicable to prior years,
t This is also reportod as $2,947,000, after an adjustment.

Fictitious Value Placed on Stock Dividends Received. —From
1922 on most of the United Cigar Stores common shares were
held by Tobacco Products Corporation, an enterprise controlled
by the same interests. This w r as an important company, the
market value of its shares averaging more than $100,000,000
in 1926 and 1927. The accounting practice of Tobacco Products
introduced still another w T ay of padding the income account,
viz., by placing a fictitious valuation upon stock dividends
received.

For the year 1926 the company’s earnings statement read as
follows:

434

SECURITY ANALYSIS

Net income. $10,790,000

Income tax. 400,000

Class A dividend. 3,136,000

Balance for common stock. 7,254,000

Earned per share. 11

Market range for common. 117-95

Detailed information regarding the company’s affairs during
that period has never been published (the New York Stock
Exchange having been unaccountably willing to list new shares
on submission of an extremely sketchy exhibit). Sufficient
information is available, however, to indicate that the net income
was made up substantially as follows:

Rental received from lease of assets to American

Tobacco Co. $ 2,500,000

Cash dividends on United Cigar Stores common

(80 % of total paid). 2,950,000

Stock dividends on United Cigar Stores common

(par value $1,840,000), less expenses. 5,340,000

$10,790,000

It is to be noted that Tobacco Products must have valued the
stock dividends received from United Cigar Stores at about
three times their face value, i.e. y at three times the value at which
United Cigar charged them against surplus. Presumably the
basis of this valuation by Tobacco Products was the market
price of United Cigar Stores shares, which price was easily
manipulated due to the small amount of stock not owned by
Tobacco Products.

When a holding company takes into its income account stock
dividends received at a higher value than that assigned them
by the subsidiary that pays them, we have a particularly danger¬
ous form of pyramiding of earnings. The New York Stock
Exchange, beginning in 1929, has made stringent regulations
forbidding this practice. (The point was discussed in Chap.
XXX.) In the case of Tobacco Products the device was espe¬
cially objectionable because the stock dividend was issued in
the first instance to represent a fictitious element of earnings,
i.e.y the appreciation of leasehold values. By unscrupulous
exploitation of the holding-company mechanism these imaginary
profits were effectively multiplied by three.

On a consolidated earnings basis, the report of Tobacco
Products for 1926 would read as follows:

ANALYSIS OF THE INCOME ACCOUNT

435

American Tobacco Co. lease income, less income

tax, etc ...

80% of earnings on United Cigar Stores common

Class A dividend.*.

Balance for common...

Earned per share.

* Excluding leasehold appreciation.

$ 2 , 100,000

6,828,000*

$7,928,000

3,136,000

$4,792,000
$ 7.27

The reported earnings for Tobacco Products common given as
$11 per share are seen to have been o^orstated by about 50%.

It may be stated as a Wall-Street maxim that where manipula¬
tion of accounts is found, stock juggling will be found also in
some form or other. Familiarity with the methods of ques¬
tionable finance should assist the analyst and perhaps even the
public, in detecting such practices when they are perpetrated. 1

SUBSIDIARY COMPANIES AND CONSOLIDATED REPORTS

This title introduces our second general type of adjustment of
reported earnings. When an enterprise controls one or more
important subsidiaries, a consolidated income account is necessary
to supply a true picture of the year's operations. Figures show¬
ing the parent company's results only are incomplete and may be
quite misleading. As previously remarked, they may either
understate the earnings by not showing all the current profits
made by the subsidiaries, or they may overstate the earnings
by failure to deduct subsidiaries' losses or by including dividends
from subsidiaries in excess of their actual income for the year.

Former and Current Practices.—In earlier years disclosure of
subsidiaries' results was a matter of arbitrary election by manage¬
ment, and in many cases important data of this kind were kept
secret. 2 For some time prior to 1933 the New York Stock

l To avoid an implication of inconsistency, because of our favorable
comments on Tobacco Products Corporation 6>£s, due 2022, in a previous
chapter, we must point out that a complete change of management took
place in this situation during 1930. There have also been two complete
changes in the management of United Cigar Stores and its successor.

2 For a discussion of the misleading effect of such policies in former years,
see references to Reading Company, Consolidated Gas Company (now
Consolidated Edison Company) and Warren Brothers Company, on pp.
380-381 of the first edition of this work. Prior to the S.E.C. legislation,
most railroad companies failed to supply any information regarding the

436

SECURITY ANALYSIS

Exchange had insisted in connection with new listings that the
results of subsidiaries be presented either in a consolidated state¬
ment or separately. But since passage of the 1934 act, all
registered companies are required to supply this information in
their annual reports to the Commission, and therefore practically
all follow the same procedure in their statements to stockholders.

Degree of Consolidation.—Even in so-called consolidated
statements the degree of consolidation varies considerably.
Woolworth consolidates its domestic and Canadian subsidiaries
but not its foreign affiliates. American Tobacco consolidates
only its wholly owned domestic subsidiaries. Most utilities now
issue consolidated reports including all companies controlled by
them (by ownership of a majority of the voting stock) and deduct
the portion of the earnings applicable to others under the heading
of “ minority interest.” 1 In the railroad field results are rarely
consolidated unless the subsidiary is both 100% owned and also
operated as an integral part of the system. Hence, Atlantic
Coast Line does not reflect its share of the results after dividends
of Louisville and Nashville, which is 51% owned but separately
operated. The same is true with respect to the 53% voting
control of Wheeling and Lake Erie held by the Nickel Plate
(New York, Chicago and St. Louis Railroad Company).

Allowance for Nonconsolidated Profits and Losses.—It is now
frequent procedure for industrial companies to indicate either
in the income account or in a footnote thereto their equity in
the profits or losses of nonconsolidated subsidiaries after allow¬
ance for dividends.

Examples: The 1938 report of American Tobacco Company
showed by way of footnote that dividends received from non¬
consolidated subsidiaries exceeded their earnings by $427,000.
Hercules Powder reported a similar figure of $257,514 for that
year, in footnote form, whereas prior to 1937 it had included its
share of the undistributed earnings of such affiliates under the
heading “ Other Income.” Railroad companies handle this

earnings of their nontransportation subsidiaries, some of which were of
substantial importance. Examples: Northern Pacific, Atchison.

1 North American Company has been somewhat exceptional in that it
consolidates only subsidiaries at least 75% owned and thus excludes two
important companies in which its interest in 1939 was 73.5 and 51 %,
respectively.

ANALYSIS OF THE INCOME ACCOUNT

437

matter differently. The Atchison, for example, now supplies
full balance sheet and income account data of affiliates in an
Appendix to its own report, which continues to reflect only the
dividends received from these companies.

The analyst should adjust the reported earnings for the results
of nonconsolidated affiliates, if this has not already been done
in the income account and if the amounts involved are significant.
The criterion here is not the technical question of control but the
importance of the holdings.

Examples: On the one hand it is not customary, nor does it
seem worth while, to make such calculations with respect to
the holdings of Union Pacific in Illinois Central and other rail¬
roads. These holdings, although substantial, do not bulk large
enough to affect the Union Pacific common stock materially.
On the other hand, the adjustment is clearly indicated in the case
of the ownership of Chicago, Burlington and Quincy stock by
Northern Pacific and Great Northern, each holding less than a
controlling interest (48.6%).

Year

Du Pont earnings
per share

Adjustments to reflect
Du Pont’s interest in
operating results of
General Motors

Earnings per
share of Du
Pont as ad¬
justed

1929

$6.99

+$2.07

$9.06

1930

4.52

+ 0 04

4.56

1931

4.30

- 0 51

3.79

1932

1.81

- 1.35

0.46

1933

2.93

+ 0.43

3 36

1934

3.63

+ 0.44

4.07

1935

5.02

+ 1 30

6 32

1936

7.53

+ 0.77

8.30

1937

7.25

+ 0 57

7.82

1938

3.74

+ 0.61

4.35

Similarly, the interest of Du Pont in General Motors, repre¬
senting about 23% of the total issue, is undoubtedly significant
enough in its effect on the owning company to warrant adjustment
of its earnings to reflect the results of General Motors. This is
actually done by Du Pont each year in the form of an adjustment
of surplus to reflect the previous year’s change in the book value
of its General Motors holdings. The analyst would prefer,

438

SECURITY ANALYSIS

however, to make the adjustment concurrently and to include it
in the calculated earnings of Du Pont. The effect of such adjust¬
ments on the earnings of Du Pont for 1929-1938 is shown in the
table on p. 437.

The report of General Motors Corporation for 1931 is worthy
of appreciative attention because it includes a supplementary
calculation of the kind suggested in this and the previous chapter
i.e., exclusive of special and nonrecurring profits or losses and
inclusive of General Motors’ interest in the results of noncon-
solidated subsidiaries. The report contains the following state¬
ment of per-share earnings for 1931 and 1930:

Earnings per Share, Including the Equity in Undivided Profits or
Losses of Nonconsolidated Subsidiaries

Including

Excluding

Year

nonrecurrent

items

1931

$2.01

$2.43

3.25

3.04

Suggested Procedure for Statistical Agencies. —Although this
procedure may seem to complicate a report, it is in fact a salutary
antidote against the oversimplification of common-stock analysis
which resulted from exclusive preoccupation with the single
figure of per-share earnings. The statistical manuals and
agencies have naturally come to feature the per-share earnings
in their analyses of corporations * They might, however, perform
a more useful service if they omitted a calculation of the per-share
earnings in all cases where the company's reports appear to
contain irregularities or complications in any of the following
directions and where a satisfactory correction is not practicable:

1. By reason of nonrecurrent items included in income or because of
charges to surplus that might properly belong in the income account.

2. Because current results of subsidiaries are not accurately reflected
in the parent company's statements.

3. Because the depreciation and other amortization charges are irregu¬
larly computed. 1

1 Standard Statistics does not calculate per-share earnings if depreciation
has not been deducted.

ANALYSIS OF THE INCOME ACCOUNT

439

Special Dividends Paid by Subsidiaries. —When earnings of
nonconsolidated subsidiaries are allowed to accumulate in their
surplus accounts, they may be used later to bolster up the results
of a poor year by means of a large special dividend paid over to
the parent company.

Examples: Such dividends, amounting to $11,000,000, were
taken by the Erie Railroad Company in 1922 from the Pennsyl¬
vania Coal Company and Hillside Coal and Iron Company.
The Northern Pacific Railway Company similarly eked out its
depleted earnings in 1930 and 1931 by means of large sums taken
as special dividends from the Chicago, Burlington and Quincy
Railroad Company, the Northern Express Company and the
Northwestern Improvement Company, the last being a real-
estate, coal and iron-on' subsidiary. The 1931 earnings of
the New York, Chicago, and St. Louis Railroad Company
included a back dividend of some $1,600,000 on its holdings of
Wheeling and Lake Erie Railway Company Prior Preferred
Stock, only a part of which was earned in that year by the
Wheeling road.

This device of concealing a subsidiary’s profits in good years
and drawing upon them in bad ones may seem quite praise¬
worthy as a method of stabilizing the reported earning power.
But such benevolent deceptions are frowned upon by enlightened
opinion, as illustrated by the more recent regulations of the New
York Stock Exchange which insist upon full disclosure of sub-
sidiaries , earnings. It is the duty of managements to disclose
the truth and the whole truth about the results of each period;
it is the function of the stockholders to deduce the “normal
earning power” of their company by averaging out the earnings
of prosperity and depression. Manipulation of the reported
earnings by the management even for the desirable purpose of
maintaining them on an even keel is objectionable none the less
because it may too readily lead to manipulation for more sinister
reasons.

Distorted Earnings through Parent-subsidiary Relationships.—

Examples are available of the use ol the parent-subsidiary rela¬
tionship to produce astonishing distortions in the reported
income. We shall give two illustrations taken from the railroad
field. These instances are the more impressive because the
stringent accounting regulations of the Interstate Commerce

440

SECURITY ANALYSIS

Commission might be expected to prevent any misrepresentation
of earnings.

Examples: In 1925 Western Pacific Railroad Corporation paid
dividends of $7.56 upon its preferred stock and $5 upon its com¬
mon stock. Its income account showed earnings slightly
exceeding the dividends paid. These earnings consisted almost
entirely of dividends aggregating $4,450,000 received from its
operating subsidiary, the Western Pacific Railroad Company .
The year’s earnings of the railroad, itself, however, were only
$2,450,000. Furthermore its accumulated surplus was insuf¬
ficient to permit the larger dividend that the parent company
desired to report as its income for the year. To achieve this
end, the parent company went to the extraordinary lengths of
donating the sum of $1,500,000 to the operating company, and
it immediately took the same money back as a dividend from its
subsidiary. The donation it charged against its surplus; the
receipt of the same money as dividends it reported as earnings .
In this devious fashion it was able to report $5 “earned” upon
its common stock, when in fact the applicable earnings were only
about $2 per share.

In support of our previous statement that bad accounting
practices are contagious, we may point out that the Western
Pacific example of 1925 was followed by the New York, Chicago,
and St. Louis Railroad Company (“Nickel Plate”) in 1930 and
1931. The details are briefly as follows:

In 1929 Nickel Plate sold, through a subsidiary, its holdings of
Pere Marquette stock to Chesapeake and Ohio, which was under
the same control. A profit of $10,665,000 was realized on this
sale, which gain was properly credited to surplus. In 1930
Nickel Plate needed to increase its income; whereupon it took tho
$10,665,000 profit out of its surplus, returned it to the subsidiary’s
treasury and then took $3,000,000 thereof in the form of a
“dividend” from this subsidiary, which it included in its 1930
income . A similar dividend of $2,100,000 was included in the
income account for 1931.

These extraordinary devices may have been resorted to for
what was considered the necessary purpose of establishing a
net income large enough to keep the company’s bonds legal for
trust-fund investments. 1 The result, however, was the same as

1 For an extreme example of this kind see the annual reports of Wabash

ANALYSIS OF THE INCOME ACCOUNT

441

that from all other misleading accounting practices, viz., to lead
the public astray and to give those “on the inside” an unfair
advantage.

Broader Significance of Subsidiaries’ Losses.—We have sug¬
gested in this chapter that security analysis must make full
allowance for the results of subsidiaries, whether they be profits
or losses. But the question may well be raised: Is the loss of a
subsidiary necessarily a direct offset against the parent company's
earnings? Why should a company be worth less because it
owns something—in this case, an unprofitable interest? Could
it not at any time put an end to the loss by selling, liquidating
or even abandoning the subsidiary? Hence, if good management
is assumed, must we not also assume that the subsidiary losses
are at most temporary and therefore to bo regarded as non¬
recurring items rather than as deductions from normal earnings?

This point is similar to that discussed in the previous chapter
relative to idle-plant expense and similar also to the matter of
unprofitable divisions of a business, to be touched upon later.
There is no one, simple answer to the questions that we have
raised. Actually, if the subsidiary could be wound up without
an adverse effect upon the rest of the business , it would be logical
to view such losses as temporary—since good sense would dictate
that in a short time the subsidiary must either become profitable
or be disposed of. But if there are important business relations
between the parent company and the subsidiary, e.g., if the latter
affords an outlet for goods or supplies cheap materials or absorbs
an important share of the overhead, then the termination of its
losses is not so simple a matter. It may turn out, upon further
analysis, that all or a good part of the subsidiary's loss is a

Railway Company and Ann Arbor Railroad Company for 1930 and the
comment thereon at p. 1022 of Moody's Manval of Investments (Steam
Railroads), 1931. The Wabash owned 99% of both the preferred and the
common stock of the Ann Arbor. In December 1930 the Ann Arbor
directors declared a $5 dividend per share on the preferred and a $27 dividend
per share on the common. This action was taken in the face of a working-
capital deficit and net earnings available o r little over 10% of the dividends
thus declared. Neither dividend was ever paid. This maneuver, however,
enabled the Wabash to credit its share of the dividends declared to its
income account as “dividend income” to the extent of $1,073,455, which
was sufficient to raise the fixed-charge coverage of the Wabash from about
1.3 times to a figure slightly in excess of 1.5 times.

442

SECURITY ANALYSIS

necessary factor in the parent company’s profit. It is not an
easy task to determine just what business relationships are
involved in each instance. Like so many other elements in
analysis, this point usually requires an investigation going well
beyond the reported figures. The following examples will
illustrate the type of situation and analysis with which we have
been dealing.

Example A: Purity Bakeries Corporation .—This large maker of
bread and cake operates through a number of subsidiaries, of
which one of the largest is Cushman’s Sons, Inc., of New York.
Cushman’s has outstanding $7 and $8 cumulative preferred stock,
not guaranteed by Purity. The annual reports of Purity are on
a consolidated basis and show earnings after deduction of full
dividends on those Cushman’s preferred shares not owned by
Purity, whether earned or paid. The separate reports of Cush¬
man’s reveal that between 1934 and 1937 its operations resulted
in a considerable loss to Purity, on its accounting basis, viz.:

(000 omitted)

Year

Purity net
income as
reported

Loss of Cush¬
man’s after full
preferred
dividends

Purity earnings
excluding
Cushman’s
operations

1937.

$463

$426

$ 889

1936.

G90

620

1,310

1935.

225(d.)

930

678

1934.

209

173

382

Average 4 years.

278 .

537

815

Per share of Purity ....

0.3G

0.71

1.06

The earnings are thus seen to be three times as large excluding
Cushman’s as they were including Cushman’s. Could the
analyst have reasoned that the former provides the truer measure
of Purity’s earning power, since the company can be expected
either again to earn money from that subsidiary (as it had earned
it in the past up to 1934) or to drop it? The question of inter¬
corporate relationships would have to be considered. A note
in the 1937 report of Cushman’s indicated that Purity was making
a fairly large service charge in connection with its subsidiaries’
operations, which suggests that Cushman’s might be of some

ANALYSIS OF THE INCOME ACCOUNT 443

extra value in absorbing overhead. This matter would call for
a careful inquiry.

But the report for the next year, 1938, showed, first, that
Cushman's had earned the preferred dividend deduction, and
secondly, that two unprofitable retail plants (in Philadelphia and
Chicago) had been closed. Subject to further investigation,
therefore, the analyst might well infer that the subsidiary's losses
were nonpermanent in nature and that the reported results for
1934-1937 are to be viewed with this point in mind.

Example B: Lehigh Coal and Navigation Company .—This
enterprise has derived its income from various sources, chief of
which has been the lease of its railroad property to the Central
Railroad of New Jersey for an annual rental of $2,268,000. Its
next largest holding consists of anthracite coal mines, which
since 1930 have been operated at a loss. In 1937 this loss was
equivalent to about 90 cents per share of Lehigh stock. As a
result the company reported a consolidated net loss of $306,000
for the year, as contrasted with a profit on a parent-company
basis only of $1,125,000, or 64 cents per share.

But in this case the analyst could not safely make the assump¬
tion that the Lehigh stock was not worth less by reason of its
ownership of the mining properties than it would be worth with¬
out them. Operation of the mines supplied an important ton¬
nage to the railroad division. If the mines were shut down, the
ability of the Jersey Central to pay the annual rental might have
been critically impaired, especially since the lessee road had been
doing poorly for some years past. (In fact the claim was later
made by the Jersey Central that the Lehigh Coal and Navigation
was obligated in connection with the lease to supply a certain
tonnage from its coal properties). Hence, in this rather compli¬
cated set-up the investor could not safely go behind the con¬
solidated results, including the losses of the anthracite subsidiary.

Example C: Barnsdall Oil Company .—We have here a situation
opposite from the other two. Barnsdall Oil owned both refining
and producing properties, the latter profitable, the former unprof¬
itable. In 1935 it segregated the refineries (and marketing
units) in a separate company, of which it distributed the common
stock to its own stockholders, retaining, however, the preferred
stock and substantial claims against the new company. In
1936-1938 the refineries and stations continued to lose; Barnsdall

444

SECURITY ANALYSIS

Oil advanced considerable sums to cover these losses and wrote
them off by charges first against capital surplus and then against
earned surplus. On the other hand, its income account , freed
from the burden of these refining losses, showed profits from
producing operations at a steady rate from June 1, 1933, to the
end of 1938.

In 1939, however, the New York Stock Exchange called upon
the company to correct its statements to stockholders by advis¬
ing them of the effect upon the reported profits of charging thore-
against the write-downs of the investment in the refining
company. These losses would have reduced the indicated profits
by more than one-third.

It is clear, from the standpoint of proper accounting, that as
long as a company continues to control an unprofitable division ,
its losses must be shown as deductions from its other earnings.
The analyst must decide what the chances are of terminating
the losses in the future, and view the current price of the stock
accordingly. The method followed by the Barnsdall Oil Com¬
pany appears therefore clearly open to criticism, since it served
merely to terminate the reporting of its refining losses without
really terminating the losses themselves. (At the end of 1939
the company set steps into motion for an apparent complete
divorcement and sale of the refining and marketing divisions.)

Summary .—To avoid leaving this point in confusion, we shall
summarize our treatment by suggesting:

1. In the first instance, subsidiary losses are to be deducted in every
analysis.

2. If the amount involved is significant, the analyst should investigate
whether or not the losses may be subject to early termination.

3. If the result of this examination is favorable, the analyst may consider
all or part of the subsidiary's loss as the equivalent of a nonrecurring item.

CHAPTER XXXIV

THE RELATION OF DEPRECIATION AND SIMILAR
CHARGES TO EARNING POWER

A critical analysis of an income account must pay particular
attention to the amounts deducted for depreciation and kindred
charges. These items differ from ordinary operating expenses
in that they do not signify a current and corresponding outlay
of cash. They represent the estimated shrinkage in the value
of the fixed or capital assets, due to wearing out, to using up
or to their approaching extinction for whatever cause. The
important charges of this character may be classified as follows:

1. Depreciation (and obsolescence), replacements, renewals or retirements.

2. Depletion or exhaustion.

3. Amortization of leaseholds, leasehold improvements, licenses, etc.

4. Amortization of patents.

All these items may properly be embraced under the title
“amortization, 77 but we shall sometimes refer to them generically
as “depreciation items, 77 or simply as “depreciation, 77 because
the latter is a more familiar term.

Leading Questions Relative to Depreciation.—The accounting
theory that governs depreciation charges is simple enough.
If a capital asset has a limited life, provision must be made to
write off the cost of that asset by charges against earnings dis¬
tributed over the period of its life. But behind this innocent
statement lie complications of a threefold character. First we
find that accounting rules themselves may permit a value other
than cost as the base for the amortization charge. Second, we
find many ways in which companies fail to follow accepted
accounting practice in stating their depreciation deduction in
the income account. Third, there are occasions when an allow¬
ance that may be justified from an accounting standpoint will
fail to meet the situation properly from an investment standpoint.
These problems will engage our attention in this and the next

445

446

SECURITY ANALYSIS

two chapters. Our discussion will be directed first towards
industrial companies generally, following which we shall consider
special aspects having to do with oil companies, mining companies
and public utilities. 1

THE DEPRECIATION BASE

Depreciation Base Other than Cost. —There is support in
accounting circles for the theory that the function of the deprecia¬
tion allowance is to provide for the replacement of the asset at the
end of its life rather than merely to write off its cost. If this idea
were actually followed, the current or expected future replace¬
ment cost would be the basis for the depreciation charge, and it
would vary not only with the value of the identical asset but also
with changes in the character of the item that is expected to
replace the one worn out.

Whatever may be said for or against this theory, 2 it is virtually
never followed in the form stated. But we do meet in practice
with a variant of the idea, viz., the substitution of the replacement
value of all the fixed assets as of a given date in place of cost on the
balance sheet, followed usually by annual depreciation charges
based on the new value.

Since 1914 there have been two waves of such revaluations.
The first, taking place in the 1920s, marked up prewar costs to the
higher values currently prevailing. The second, appearing in
1931-1933, marked down property accounts to the much lower
valuations associated with the depression. 3

Examples: In 1926 American Ice Company wrote up its fixed
assets by $7,868,000, and in 1935 it wrote them down correspond¬
ingly to restore the valuations to a cost basis. The 1926 write-up
resulted in larger depreciation charges thereafter against income,

1 With a very few exceptions the railroads charge depreciation only on
their equipment (including this item in the maintenance charges). For the
year 1937 Class I railroads charged a total of $191,798,000 for depreciation
of equipment and only $5,236,000 for depreciation of way and structures.

* In our view it is at once simpler and more logical to base depreciation on
original cost. Replacement cost should affect the accounts after replacement
takes place (which may never happen) rather than before.

* See Fabricant, Solomon, “Revaluations of Fixed Assets, 1925-1934”

(National Bureau of Economic Research Bulletin 62, .1936), and Capital
Consumption and Adjustment , National Bureau of Economic Research,
Chap. XII, 1938.

ANALYSIS OF THE INCOME ACCOUNT

447

and the 1935 reduction resulted in lower depreciation charges.
In 1933 American Locomotive Company reduced the stated value
of its stock from $50 to $5 a share and utilized most of the capital
surplus thus created to write down fixed properties by nearly
$26,000,000 and its investment in General Steel Castings Corpora¬
tion by about $6,200,000. The net effect on the income account
was to reduce depreciation charges to about 40% of their former
level.

There is some criticism in accounting circles of the propriety of
such sporadic changes in the depreciation base from original cost.
In our opinion they are not objectionable 'provided:

1. The new values are set up in the bona fide conviction that they repre¬
sent existing realities more fairly ilian the old values.

2. Proper depreciation against these new values is charged in the income
account.

In many cases, however, we find that companies revaluing their
fixed assets fail to observe one or the other of these conditions.

Mark-downs to Reduce Depreciation Charges.—Perhaps the
most striking phenomenon in the field of depreciation accounting
is the recent marking down of the fixed assets, not in the interests
of conservatism but with the precisely opposite intent of making
a better earnings exhibit and thereby increasing the apparent
value of the shares.

We believe that it will be more convenient for the reader if we
defer consideration of the significance to security analysis of these
devices until our chapter devoted to “Amortization Charges from
the Investor’s Standpoint.” At this time, since we are dealing
with accounting methods, we shall merely remark that in our
opinion excessive write-downs of fixed assets, for the avowed or
obvious purpose of decreasing depreciation and increasing
reported earnings, constitute an inexcusable subterfuge and
should not be condoned by the accounting profession. Registra¬
tion statements submitted to the S.E.C. include a statement of
how much lower the earnings would have been if the former plant
values had been retained. We think that such information
should also appear as a footnote to the income account in the
annual reports to stockholders, but it would be better practice
still if accountants refused to certify a report containing such
mark-downs and insisted on restoration of the proper figures to
the company’s accounts.

448

SECURITY ANALYSIS

Balance Sheet-Income Account Discrepancies. —Many cor¬
porations that have marked up their fixed assets fail to increase
correspondingly their depreciation charges against the income
account. They are in effect attempting to get the benefit of the
higher valuation in their balance sheet without accepting the
burden of consequently higher depreciation charges against
earnings. This practice has been especially prevalent in the case
of mining and oil companies. Two examples drawn from the
general industrial field are given here:

Examples: Hall Printing Company wrote up its property
account by $6,222,000 in 1926 and 1931, crediting this “ appraisal
increment” to capital surplus. Depreciation on this appre¬
ciated value was then charged to capital surplus, instead of to
income; e.g. } typically, in the year ended March 1938 the com¬
pany charged $406,000 for such depreciation against surplus and
$864,000 for “regular” depreciation against income. In April
1938 the balance of the appraisal increment was eliminated by
writing down both property account and capital surplus; and the
special depreciation charge was then discontinued.

Borg Warner has been charging about $102,000 per annum
since 1935 (and various amounts in prior years) to “ Appreciation
Surplus,” instead of to income, to amortize a write-up of fixed
assets made in 1927.

It should be obvious that no company should use one set of
values for its balance sheet and another for its income account.
The more recent tendency is to correct these disparities by
eliminating the previous write-up from the balance sheet, thus
returning to original cost.

THE RATE OF DEPRECIATION. STANDARD AND NONSTANDARD

PRACTICE

1. As Shown by Listing Statements. —The vast majority of
industrial companies follow the standard policy of charging an
appropriate depreciation rate against each class of depreciable
asset. The analyst can readily check this fact by reference to
New York Stock Exchange listing applications or to a prospectus
or registration statement.

Examples: If standard methods are followed, they are likely
to be announced in somewhat the following manner:

ANALYSTS OF THE INCOME ACCOUNT

449

(From listing application of Electric Storage Battery Com¬
pany, dated December 17, 1928.)

The policy of this Company in regard to depreciation ... is as
follows: On buildings the term of*life is twenty to thirty-three years,
depending upon the character of construction. Machinery, tools and
fixtures are written off at the rate of one to ten years, depending upon the
character of the equipment. Office furniture and fixtures are written
off in ten years. Oil all depreciable properties rates are determined by
actual experience and engineers’ estimates as to the productive life of
the equipment. In respect to depreciation current assets, a reserve
is set aside to cover probable loss from bad debts.

(From the listing application of Midland Steel Products Com¬
pany, dated February 11, 1930.)

The following are the rates of depreciation used:

Rate of Depre¬
ciation per Year,
%

Buildings. 2

Grounds, driveways and walks. . 2

Machinery. 7

Furniture and fixtures. . 10

Railroad sidings. 2

Automobiles and trucks.25

Tools and dies—amortized over life of job when number of
units required can be determined, otherwise written off at close
of each fiscal year.

These rates have been used by the Company for several years, being
standard practice in the industry.

The rates are based upon the estimated life of the respective property
involved. Thus, with respect to buildings, the cost is depreciated, over
50 years; grounds, driveways, and walks, over 50 years; machinery over
14 years; furniture and fixtures, over 10 years; railroad sidings, over 50
years. No residual value at the expiration of said periods is considered
in determining the rates used.

In contrast with this standard policy, now all but universally
followed, we may point to the questionable practice on this
important point formerly resorted to by such important com¬
panies as American Car and Foundry, American Sugar Refining
and Baldwin Locomotive Works.

450

SECURITY ANALYSIS

The American Sugar Refining Company’s listing application,
dated December 6, 1923, contained the following statement:

The Company maintains a very liberal policy as to depreciation as
shown by the annual profit and loss statement of past years. The value
of its properties is at all times fully maintained by the making of all
needful and proper repairs thereto and renewals and replacements
thereof.

This declaration sounds reassuring, but it is far too indefinite
to satisfy the analyst. The actual depreciation charges, as
shown in the following record, disclose an unusually arbitrary
and erratic policy.

Annual Charges by American Sugar Refining Company for
Depreciation

Year

Charged to
income

Charged to
surplus

1916-1920

52,000,000

None

1921

None

1922-1923

1,000,000

None

1924

None

1925

1,000,000

None

1926

1,000,000

$2,000,000

1927

1,000,000

1928

1,250,000

500,000

1929

1,000,000

500,000

1930

1,000,000

542,631

1931

1,000,000

None

1932

1,000,000

None

The additional charges to surplus made in the years 1926-1930,
inclusive, appear to strengthen our contention that American
Sugar’s depreciation allowances have been both arbitrary and
inadequate.

The American Car and Foundry’s application, dated April 2,
1925, contains the following:

The Company has no depreciation account as such. However, its
equivalent is found in the policy and the practice of the Company to
maintain at all times its plants and properties in first class physical
condition and in a high state of efficiency by repairing, renewing and
replacing equipment and buildings as their physical conditions may

ANALYSIS OF THE INCOME ACCOUNT

451

require, and by replacing facilities with those of more modern type,
when such action results in more economical production. This proce¬
dure amply covers depreciation and obsolescence and the cost is charged
to Operating Expenses.

Here again a sceptical attitude on the part of the analyst is
“amply” warranted. The same is true in respect of American
Can which managed—inexplicably—to avoid all reference to its
depreciation policy in its listing application dated February 26,
1926, although it did mention that the company had spent
approximately $50,000,000 on extensions and improvement of
properties since February 1907 and that “during this period
properties have been depreciated by at least $20,000,000.”

Baldwin Locomotive Works, in its listing application dated
October 3,1929, makes the following rather astonishing statement
on depreciation:

The amount of the depreciation upon plant and equipment as deter¬
mined by the Federal Government for the five years 1924 to 1928 inclu¬
sive has totaled $5,112,258.09 which has been deducted either from
income or surplus as follows:

Year

From

income j

From

Burplus

Total

depreciation

1924

a goo,ooo

none

$ 600,000.00

1925

none

1926

none

1927

1,000,000

$2,637,881.01

3,637,881.01

1928

600,000

274,377.08

874,377.08

$2,200,000

£2,912,253.00

$5,112,258.09

It is expected that in future years the amount of depreciation based
upon the estimated useful life of depreciable properties as determined
by the Federal Government, allowed by the Commissioner of Taxes as
a proper deduction from income and agreed to by our engineers, will
govern the amount to be used by the Works in its calculation of
depreciation.

Evidently the income statements of Baldwin for this period
were anything but accurate. The average annual earnings per
share of common stock for 1924-1928, as reported to the stock¬
holders, were strikingly higher than the correct figure, as shown
•a page 452.

452

SECURITY ANALYSIS

Earnings per Share op Common

Year

As reported

As corrected for
annual deprecia¬
tion charge of
$1,022,000

1924

$ 0 . 40 (d)

$ 2.61(d)

1925

6.02(d)

11.13(d)

1926

22.42

17.31

1927

5 21

5.10

1928

6.84(d)

7.45(d)

6-year average.

S 3.33

$ .06

2. As Shown by Comparisons of Two Companies. —When the
analyst knows that a company’s depreciation policy differs from
the standard, there is special reason to check the adequacy of the
allowance. Comparison with a single company in the same field
may yield significant results, as is shown by the following data
respecting American Sugar and American Car and Foundry.

Company

Average
property
account (net)
1928-1932

Average de¬
preciation
charge
1928-1932

% of deprecia¬
tion charge to
property
account

American Sugar Refining...

$ 60,665,000

$1,050,000*

1.73f

National Sugar Refining...

19,250,000J

922,0001

4.791

American Car and Foundr}'.

72,000,000

1,186,000§

1 65

American Steel Foundries.

31,000,000

1,136,000

3 66

* Exclusive of depreciation charged to surplus. Including the latter, this figure would be
$1,358,500.

t Including depreciation charged to surplus this figure would be 2.24%.

X Based on the four years 1929-1932, inclusive. Figure for 1928 unavailable.

{ Estimated at one-half of the expenditures for renewals and repairs. In the case of
United States Steel for the period 1901-1933, the charge for depreciation averaged about
40 % of the total allowances for both maintenance and depreciation.

Both comparatively and absolutely the depreciation allowances
made by American Sugar and American Car and Foundry appear
to have been inadequate. 1

1 For examples of insufficient charges and charges less than income
tax deductions by industrial companies see: Harbison-Walker Refractories

ANALYSIS OF THE INCOME ACCOUNT

453

Depreciation Charges Often an Issue in Mergers.—Compara¬
tive depreciation charges at times become quite an issue in deter¬
mining the fairness of proposed terms of consolidation.

Example: In 1924 a merger plan was announced embracing
the Chesapeake and Ohio, Hocking Valley, Pere Marquette,
“Nickel Plate” and Erie railroads. Some Chesapeake and
Ohio stockholders dissented, and they convinced the Interstate
Commerce Commission that the terms of the consolidation
were highly unfair to their road. Among other matters they
pointed out that the earnings of Chesapeake and Ohio in the
preceding three years had in reality been much higher than
stated, due to the unusually heavy charges made against them
for depreciation and retirement of equipment. 1 A similar objec¬
tion was made in connection with the projected merger of
Bethlehem Steel and Youngstown Sheet and Tube in 1929,
whieli plan was also defeated. Some figures on these two steel
producers are given as shown in the table on p. 454.

Concealed Depreciation. —That nothing can be taken for
granted in security analysis is shown by the strange case of
American Can, which until 1937 had failed to reveal details of its
depreciation policy to its shareholders. During the years 1922-

Company charge of $296,000 in 1936, termed “grossly inadequate” by new
management and revised to $472,000; McKeesport Tin Plate Corporation
report for 1937 stating that the charge on the income tax return was $803,000
vs. $425,000 in statement to stockholders. Similarly, National Enameling
and Stamping Company for each year 1935-1937 charged about $185,000 in
its income account as contrasted with about $280,000 on its tax return.
In 1938 insufficient depreciation for 1933-1937 was cured by a charge
of $443,000 to surplus. The auditors for the Cudahy Packing Company
stated in the certificate accompanying the 1939 report that in their opinion
the reserves for depreciation set up by the company in years prior to Oct.
29, 1938, were inadequate.

Conversely, for cases of excessive depreciation, note: Depreciation
charges of Acme Steel for 1932-1935 were found by the federal government to
have been $555,000 too high. This amount, less income tax thereon of
$104,000, was credited to surplus in 1936. (This is almost the exact opposite
of the National Enameling case.) Chicago Yellow Cab Company in 1938
credited to surplus $483,000 for excess depreciation in former years.

1 Large expenditures made by Chesapeake and Ohio upon its equipment
in 1926-1928 and charged to operating expense were later claimed by the
Interstate Commerce Commission to represent capital outlays. In 1933
this controversy was taken into the courts, and the Interstate Commerce
Commission was sustained.

454

SECURITY ANALYSIS

1936 it deducted anually a flat $2,000,000 for this purpose. A
comparison with Continental Can—which charged about the
same amount against a much smaller plant investment—would
have suggested that American Can’s earning power had been
overstated. But the annual report for 1934 disclosed to stock¬
holders for the first time that the company had also been charging
sums to operating expenses for “replacements,” without giving
the amount. The fact (but not the amounts) that such charges
had been made in 1935 and 1936 was also revealed in those years.
Meanwhile Form 10-K for 1935, filed with the S.E.C., revealed
that the amount of these extra charges was about $2,400,000.
Finally the annual report for 1937 advised the stockholders that
the corresponding extra charge-off amounted to approximately
$3,275,000 for the year 1936. Beginning with 1937 the company
made “regular” depreciation charges, amounting to $5,702,000
in that year and to $6,085,000 in 1938. Thus, by easy stages,
the owners of the business were told the facts of life bearing on
their property.

1928

Bethlehem

Steel

Youngstown
Sheet & Tube

Property account, Dec. 31, 1927.

$673,000,000

295,000,000

13,658,000

2.03%

4.63%

$204,000,000

141,000,00

8,321,000

4.08%

5.90%

Sales.

Depreciation, depletion, and obsolescence
Ratio: depreciation to property account..
Ratio: depreciation to sales.

In the light of this later disclosure, the earlier inference 1 that
American Can had understated its depreciation charges must give
way to the remark that the company had failed to reveal the facts.

A Case of Excessive Depreciation Charges Concealed by
Accounting Methods. —The American Can example suggests
comparison with the earlier practice of National Biscuit Com¬
pany, an enterprise controlled largely by the same interests. For
many years prior to 1922 the company was constantly adding
to the number of its factories, but its property account failed to
show any appreciable increase, except in the single year 1920.
The reports to stockholders were supremely ambiguous on the
1 Drawn in the 1934 edition of this book.

ANALYSIS OF THE INCOME ACCOUNT

455

matter of depreciation charges, 1 but according to the financial
manuals the company’s policy was as follows: “Depreciation is
$300,000 per annum, and all items of replacement and building
alterations are charged direct to operating expense.”

National Biscuit Company

Year ended

Earnings for
common stock

Net plant
account at
end of year

Jan. 31, 1911 .

S 2,883,000

$53,159,000

1912.

2,937,000

53,464,000

1913.

2,803,000

53,740,000

1914.

3,432,000

54,777,000

1915.

2,784,000

54,886,000

1916.

2,393,000

55,207,000

1917.

2,843,000

55,484,000

Dec. 31, 1917 .

2,886,000 (11 mo.)

53,231,000

1918.

3,400,000

52,678,000

1919 .

3,614,000

53,955,000

1920 .

3,807,000

57,788,000

1921.

3,941,000

57,925,000

1922.

9,289,000

61,700,000

1923.

10,357,000

64,400,000

1924.

11,145,000

67,292,000

1925.

11,845,000

69,745,000

It is difficult to avoid the conclusion, however, that the
capital investments in additional plants were actually being
charged against the profits and that the real earnings were in
all probability much larger than those reported to the public.
Coincident with the issuance of seven shares of stock for one
and the tripling of the cash-dividend rate in 1922, this policy
ot understating earnings was terminated. The result was a
sudden doubling of the apparent earning power, accompanied
by an equally sudden expansion in the plant account. The
contrast between the two periods is shown forcibly in the table
on this page.

1 Prior to 1919, the company's balance sheet each year stated its fixed
assets “Less Depreciation Account—$300,000." Evidently this was the
deduction for the current year and not the amount accumulated.

456

SECURITY ANALYSIS

Failure to State Depreciation Charges. —Prior to the S.E.C.
regulation some of the important companies reported earnings
after depreciation but failed to state the amount deducted for this
purpose. Fortunately, this information must now be supplied in
the case of every registered company. 1

AMORTIZATION CHARGES OF OIL AND MINING COMPANIES

These important sectors of the industrial field arc subject to
special factors bearing on amortization. In addition to deprecia¬
tion in the ordinary sense—which they usually calculate in the
same way as do other companies 2 —they must allow for depletion
of their ore or oil reserves. In the case of mining concerns there
is also the factor of development expense. Oil producers, on the
other hand, have additional charges for intangible drilling costs
and for unproductive leases. These items are important in their
bearing on the true profits, and they are troublesome because of
the varying methods that are followed by different enterprises.

Depletion Charges of Mining Companies.—Depletion repre¬
sents the using up of capital assets by turning them into products
for sale. It applies to companies producing metals, oil and gas,
sulphur, timber, etc. As the holdings, or reserves, of these
products are exhausted, their value must gradually be written
off through charges against earnings. In the case of the older
mining companies (including particularly the copper and sulphur
producers) the depletion charges are determined by certain
technical requirements of the federal income tax law, which rest
upon the amount and value of the reserves as they were supposed
to exist on March 1, 1913, or by applying certain percentages to
the value of the product. Because of the artificial base used
in these computations, many companies have omitted the deple¬
tion charge from their reports to stockholders.

1 Allied Chemical and Dye Corporation endeavored to have this and other
data held confidential, but after considerable delay it was made public
(in 1938). This company, like a few others, still excludes its sales and
depreciation figures from its reports to stockholders, but this important
information is available in the annual reports to the S.E.C. (Form 10-K).

* However, the cost of equipment and materials on oil-producing properties
is often written off through the depletion charge (which is based on the
barrels produced) instead of the depreciation account (which is based on the
time elapsing).

ANALYSIS OF THE INCOME ACCOUNT

457

Independent Calculation by Investor Necessary. —As we shall
show later, the investor in a mining concern must ordinarily
compute his own depletion allowance, based upon the amount
that he has paid for his share of .the mining property. Conse¬
quently a depletion charge based either on the company's
original book cost or on the special figure set up for income-tax
purposes would be confusing rather than helpful. The omission
of the depletion charge of mining companies is not to be criticized,
therefore; but the stockholder in such enterprises must be well
aware of the fact in studying their reports. Furthermore, in
any comparison of mining companies a proper distinction must
be drawn between those which do and those which do not deduct
their depletion charges in reporting their earnings. Following
are some examples of companies that pursue one or the other
policy:

Companies That Report Earnings Companies That Report Earnings
without Deduction for Depletion: after Deduction for Depletion:

Alaska Juneau Gold Mining Co. Cerro de Pasco Copper Corp.

Anaconda Copper Mining Co. Granby Consolidated Mining, etc.,

Co. (copper)

Dome Mines, Ltd. (gold) Homcstake Mining Co. (gold)

Kennecott Copper Corp. International Nickel Co. of

Canada, Ltd.

Noranda Mines, Ltd. (copper and Patino Mines, etc. (tin)
gold)

Texas Gulf Sulphur Co. Phelps Dodge Corp. (copper)

St. Joseph Lead Co.

Depletion and Similar Charges in the Oil Industry.—In the oil

industry depiction charges are more closely related to the actual
cost of doing business than in the case of mining enterprises. The
latter ordinarily invest in a single property or group of properties,
the cost of which is then written off over a fairly long period of
years. But the typical large oil producer normally spends sub¬
stantial sums each year on new leases and new wells. These
additional holdings are needed to make up for the shrinkage of
reserves through production. The depletion charge corresponds
in some measure, therefore, to a current cash outlay for the
purpose of maintaining reserves and production. New wells
may yield as high as 80% of their total output during the first
year. Hence nearly all the cost of such “flush production" must
be written off in a single fiscal period, and most of the “earnings”

458

SECURITY ANALYSIS

from this source are in reality a return of the capital expended
thereon. If the investment is not written off rapidly through
depletion and other charges, the profit and the value of the
property account will both be grossly overstated. In the case of
an oil company actively engaged in development work, the
various headings under which write-offs must be made include
the following:

1. Depredation of tangible assets.

2. Depletion of oil and gas reserves, based upon the cost of the leases.

3. Unprofitable leases written off. Part of the acquisitions and explora¬
tion will always prove totally valueless and must be charged against the
revenue from the productive leases.

4. Intangible drilling costs. These are either written off at one time, as
equivalent to an operating expense, or amortized over the life of the
well.

Example: The case of Marland Oil in 1926 illustrates the
extent to which reported earnings of oil companies are dependent
upon the accounting policies with respect to amortization. This
company spent large sums annually on new leases and wells
to maintain its rate of production. Prior to 1926 it charged the
so-called “intangible drilling costs” to capital account and then
wrote them off against earnings through an annual amortization
charge. In 1926 Marland adopted the more conservative policy
of charging off all these “intangible costs” currently against earn¬
ings. The effect on profits is shown in the following table.

Marland Oil Company

Item

1926

1927

Gross earnings and miscellane¬
ous income.

$73,231,000

24,495,000

9,696,000

14,799,000

$87,360,000

30,303,000

18,612,000

11,691,000

$58,980,000

9,808,000

17,499,000

7, 601,000(d)

Net before reserves.

Amortization charges.

Balance for stock.

In the past ten years significant changes have occurred in the
policies followed by the important oil companies. Prior to
the depression the general tendency was towards charging the
“intangible drilling costs” to earnings—as shown in the change
made by Marland in 1926. But since the depression many of

ANALYSIS OF THE INCOME ACCOUNT

459

the large companies have switched over to the less conservative
basis of capitalizing these costs, subject to annual amortization. 1
This change seems justified in good part by the wide adoption
of state proration laws, which effectively spread out the total
production of a new well over many years instead of concentrating
it within a relatively few months. This makes an oil well a
fairly long-term capital asset, so that charging off a good part of
its cost (now often running to very high figures) against a single
year’s profits would be unduly severe.

The companies have also aided their earnings by large write¬
downs of fixed assets, with corresponding reductions in the annual
amortization charges against them. This practice has perhaps
been more widespread among oil companies than in any other
industrial group. Some producers have also switched their
charges for property retirements from earnings to the depreciation
reserve. Finally, we have examples of a reduction in amortiza¬
tion charge being brought about by adoption of an “ over-all
basis” instead of a lease basis for depletion. By this means,oil
produced from high-cost leases is written off not at its actual cost
but at the average cost of all the oil reserves owned.

The significance of these changes in accounting policy is
illustrated by the following: 2

Examples: Gulf Oil Corporation increased its 1932 earnings by
$3,621,000, by capitalizing intangible drilling costs instead of
charging them off, as formerly.

Socony-Vacuum increased its 1932 earnings by $6,095,000 (and
subsequent earnings correspondingly) as a result of a write-down
of fixed assets with consequent reduction in depreciation charges.
In 1935 its profits were increased $1,376,000 by charging this
sum—representing losses on certain retired property—to depre¬
ciation reserve instead of to income, as theretofore. In 1936 it
began to capitalize intangible drilling costs, adding about $8,850,-
000 to profits in that year through this change. In 1937 the
company made a further revision in its depreciation policy
(apparently intended to place it on the standard basis), which
added some $2,500,000 to that year’s profits.

1 Companies making this change since 1930 include Standard Oil of
Indiana and New Jersey, Gulf Oil, Tidewater Associated, Consolidated Oil.

* These examples are drawn largely from Alfred Braunthal, "Are Oil
Earnings Reports Fictitious?" Barron's , Mar. 8, 1937.

460

SECURITY ANALYSIS

Pure Oil Company reduced its 1934 depletion charges and
increased its earnings by $1,698,000 through adoption of the
“over-all” basis.

The Meaning of These Variations to the Analyst and the
Investor. —These differences of accounting methods are highly
confusing and may arouse some resentment in the investor.
We must recognize, however, that most of them are technically
admissible, in that they represent choices between the ordinary
and the more conservative basis of amortizing the fixed assets.
What is called for, in consequence, is not so much censure as
sound interpretation.

Suggested Standards. —The analyst should seek to apply a
uniform and reasonably conservative rate of amortization to a
property base that reflects the realities of the proposed invest¬
ment. We suggest the following standards, in so far as it may
be feasible to apply them:

1. Depreciation on Tangible Assets. —This should always be
taken at the well-established rates, applied to cost—or to a figure
substantially less than cost only if the facts clearly justify the
write-down.

2. Intangible Drilling Costs. —We believe that capitalizing
these costs, and then writing them off as oil is produced—
although less “conservative”—is the preferable basis both for
comparative purposes and to supply a fair reflection of current
earnings. In comparing companies that use one and the other
method, the analyst must make the best allowance he can for the
understatement of earnings by the companies that charge off
100% the first year.

Example: The difficulty of making this adjustment in practice
may be shown by comparing the 1938 reports of Continental Oil
Company and Ohio Oil Company. These two concerns are
roughly similar in their set-up. Both produced about 20 million
barrels in 1938; Continental Oil refined about two-thirds,
and Ohio Oil about one-third its output. Continental charges
all its intangible drilling costs direct to income, while Ohio
capitalizes these costs and writes them off over the life of the
wells.

It might be expected that the total amortization charges of
Continental, including drilling expense on the 100% basis, would
be relatively higher than those of Ohio. Yet in 1938 Ohio

ANALYSIS OF THE INCOME ACCOUNT

461

charged off $11,602,000, or 21)^% of its $54 million sales; while
Continental charged off $14,038,000, or 17.6% of its $80 million
gross. Apparently no adjustment would be needed by the
analyst to equalize the two accounting methods. The reasons
may be found in several circumstances; e.g., (a) after a number of
years the gradual write-off method approximates the 100%
method, since amortization of old drilling expense becomes
continuously greater. ( b ) In the case of Continental, this
concern wrote down its property account in 1932 by some
$45,000,000 and thus reduced its normal depreciation and
depletion charges considerably in succeeding years.

3. Property Retirement and Abandoned Leases .—We think that
loss on property retired (in excess of depreciation already accrued)
should be charged against the year’s earnings, rather than against
surplus as is done by most companies in other fields. The reason
is that property retirements are likely to be a normal and recur¬
rent factor in the business of a large, integrated oil company,
instead of happening only sporadically as in other lines. Aban¬
doned leases come under this general heading, and the loss
thereon should be charged to earnings.

4. Depletion of Oil Reserves. —The proper theoretical principle
here is that the analyst should allow for depletion on the basis at
which the oil reserves are valued in the market. This point, as
applied to amortization generally, will be discussed in the next
chapter. It implies, as we shall see, that what may be the correct
accounting basis for computing depletion may not be the most
suitable basis for the analysis of investment values.

Unfortunately, business practice in the oil industry has been
such as to make the sound application of this principle exceed¬
ingly difficult. The oil-producing part of the industry has
apparently accounted for most of the profits; the refining and
marketing divisions have earned little, if anything, on their
investment. If earnings were the criterion of value here, most
of the market price of a typical oil stock would be ascribable to
the producing division, and on this bn sis a comparatively high
depletion charge against each barrel taken out would be called for.
On the other hand, if the division were made in proportion to
book values , the refining and marketing sections would loom large,
the oil reserves would have a much smaller value, and the deple¬
tion charge would be proportionately smaller.

462

SECURITY ANALYSIS

We do not see any really satisfactory answer to the dilemma
that we have posed—for it seems to us that the partition of
earning power in the industry between production and the other
branches is an essentially artificial one and cannot be viewed as
permanent. We therefore are led to suggest the following 'practi¬
cal compromise with the problem:

1. In the case of integrated oil companies, accept the company's depletion
figure as the best available. (This includes acceptance of the “over-air'
basis, if used, since this method would seem to reflect the facts fairly.)
However, any charges for depletion made against an “appreciation" account
in the balance sheet should be deducted from income.

2. In the case of companies that are solely oil producers, or virtually so,
the analyst can compute what the market is paying for the total developed
oil reserves (if an estimate of these is published). Hence he can make his
own depletion calculation, for the particular purpose of his analysis, in such
an instance in the same manner as in the case of a mining proposition.
(For a calculation of this kind applied to Texas Gulf Producing Company
see p. 496.)

OTHER TYPES OF AMORTIZATION OF CAPITAL ASSETS

Leaseholds and Leasehold Improvements.—The ordinary
lease involves no capital investment by the lessee, who merely
undertakes to pay rent in return for the use of property. But
if the rental payments are considerably less than the use of the
property is worth, and if the arrangement has a considerable
period to run, the leasehold—as it is called—may have a sub¬
stantial value. Oil lands are leased on a standard basis for a
royalty amounting usually to one-eighth of the production.
Leaseholds on which a substantial output is developed or assured
are worth a large bonus above the rental payments involved, and
they are bought and sold in the same way as the fee ownership
of the property. Similar bonuses are paid—in boom times
usually—for long-term leases on urban real estate.

If a company has paid money for a leasehold, the cost is
regarded as a capital investment that should be written off
during the life of the 'lease. (In the case of an oil lease the
write-off is made against each barrel produced, rather than on a
time basis, since the output declines rapidly from the initial
flush figure.) These charges are in reality part of the rent paid
for the property and must obviously be included in current
operating expense.

ANALYSIS OF THE INCOME ACCOUNT

463

When structures are built on leased property or alterations
made or fixtures installed, they are designated as “ leasehold
improvements.” Hence their cost must be written down to
nothing during the life of the lease, since they belong to the
landlord when the lease expires. The annual charge-off for
this purpose is called “amortization of leasehold improvements.”
It partakes to some extent of the nature of a depreciation charge.
Chain-store enterprises frequently invest considerable sums in
such leasehold improvements, and consequently the annual
write-offs thereof may bo of appreciable importance in their
income accounts.

Example: The December 31, 1938, balance sheet of F. W.
Woolworth Company carried “Buildings Owned and Improve¬
ments on Leased Premises to be amortized over periods of leases”
at a net valuation of $46,717,000. The charge against 1938
earnings for amortization of these buildings and leasehold
improvements amounted to $3,925,283.

Since these items belong to the amortization group, they lend
themselves to the same kind of arbitrary treatment as do the
others. By making the annual charge against surplus instead
of income or by writing down the entire capital investment to $1
and thus eliminating the annual charge entirely, a corporation
can exclude these items of operating cost from its reported
per-share earnings and thus make the latter appear deceptively
large.

Amortization of Patents.—In theory, a patent should be dealt
with in exactly the same way as a mining property; i.e., its cost to
the investor should be written off against earnings during its
remaining life. It is obvious, therefore, that charges made
against earnings by the company—which are based on the book
value of the patent—have ordinarily little relevance to the real
situation. Consideration of this question belongs chiefly to a
later chapter on amortization from the investor's standpoint, and
to avoid dividing our treatment we shall postpone to the same
place our brief discussion of the accounting methods relative to
patents encountered in corporate reports.

Amortization of Good-will.—This is a matter of very minor
importance. A few companies have followed the rather extra¬
ordinary policy of charging off their good-will account against
earnings in a number of annual installments.

464

SECURITY ANALYSIS

Examples: Radio Corporation of America charged $310,000
a year for this purpose between 1934 and 1937. This was
applicable to the good-will account of its subsidiary National
Broadcasting Company and was discontinued in 1938, although
$1,876,000 remained unamortized.

Obviously, this practice has no factual basis, since good-will
has no duration of life apart from that of the business as a whole.
Where the item is of any size, the analyst should adjust the
earnings by canceling the charge.

CHAPTER XXXV

PUBLIC-UTILITY DEPRECIATION POLICIES

Omission of Depreciation Charges. —In no field does the
question of proper depreciation policy have such practical
importance as in the public-utility group. Yet nowhere have
there been wider variations in both theory and practice. Some
years ago there were instances—notably that of Cities Service
Company—of complete failure to make any deduction for
depreciation (and depletion) in the annual reports, with a result¬
ant gross misstatement of the earnings for the stock. 1 The
argument has often been advanced that depreciation charges
may properly be ignored because they are mere bookkeeping
entries and do not represent a real outlay of cash. This is a
highly inaccurate statement of the case. Depreciation is not a
mere bookeeping conception, because for the most part it registers
an actual diminution of capital values, for which adequate
provision must be made if creditors or owners arc to avoid deceiv¬
ing themselves. 2

Moreover, in the majority of cases the depreciation charges
are consumed or offset over a period of time by even larger cash
expenditures made for replacements or extensions. More often
than not, therefore, depreciation charges are eventually found to
be related to actual cash outlays and turn out to be as truly an
expense of the business as wages or rents. Minority cases are
fairly numerous in which a good part of the depreciation reserve

!In 1925, for example, the company reported earnings of $11,497,000
‘for common stock and reserves/ 7 said to amount to $3.05 per share. But
the depreciation and depletion charges must have amounted to more than
this balance, leaving actually nothing earned for the stock. Yet in that year
it sold as high as 43.

* In answer to the frequent argument that a depreciation allowance is
unnecessary because liberal repairs keep the assets good, we may quote
Hatfield's classic sentence: “ All machinery is on an irresistible march to the
junk heap, and its progress, while it may be delayed, cannot be prevented
by repairs." Henry R. Hatfield, Accounting: Its Principles and Problems ,
p. 130, New York, 1928.

465

466

SECURITY ANALYSIS

remains unexpended over a long period of time. In these
instances a reduction of the annual charges may sometimes be
justified in the investor’s calculations, as we shall later explain.
The broad principle remains, however, that an adequate deprecia¬
tion allowance is essential in arriving at a fair statement of
earnings.

Other Misleading Practices.—Another fairly prevalent prac¬
tice was the deduction of only part of the depreciation charge
from earnings, the balance being taken out of the surplus account.
In some instances the amounts charged to income were based
on the so-called “indenture minima”—a percentage of gross
earnings for maintenance and depreciation combined required
to be deducted under the terms of a bond issue. When these
indenture minima were less than the depreciation actually needed
and taken, we find that requirements ostensibly set up for the
protection of investors were actually used to mislead them. 1

It is unfortunate that something resembling this practice has
been resorted to at times by conservatively managed companies.
Note the following in the reports of the Detroit Edison Company
for 1931 and 1930.

Item

1931

1930

Gross.

$49,233,000

21,421,000

4,000,000

8.1%

5,992,000

11,429,000

$8.98

$53,707,000

24,041,000

6,900,000

12.8%

6,024,000

11,117,000

$8.75

Net before depreciation.

Depreciation.

(Per cent of gross).

Fixed charges.

Balance for common.

Earned per share.

Additional depreciation charged to sur¬
plus .

1,500,000

$7.80

Earned per share after charge to surplus

$8.75

Although Detroit Edison’s depreciation charges have been
unusually liberal by comparison with the average for the industry,
the accounting method employed for 1931 (and also in 1934)
might well be criticised for two reasons. In the first place its

1 In the case of Cities Service Power and Light, these understatements of
depreciation appeared both in the annual reports and in the bond-offering
circulars. For the data relating to 1925 see the discussion on p. 175.

ANALYSIS OF THE INCOME ACCOUNT

467

effect, if not its purpose, was to disguise the actual decline in
earnings from the previous year. Secondly, because of the high
reputation of the company, this device was likely to be imitated
by other enterprises, and thus it might furnish an unwholesome
stimulus to the new practice of overstating earnings by the
transfer of charges to the surplus account.

An Illustration of Tricky Accounting. —An extraordinary
example of tricky accounting is displayed by Iowa Public
Service Company. For 1929 this company reported a property
account of $25,200,000, gross earning" of $4,200,000 and a
depreciation charge of only $78,000. The inadequacy of this
figure is patent. In succeeding years the depreciation allowance
was gradually increased, reaching $220,000 in 1932, which w T as
still a somewhat subnormal figure. In 1932, the company made
formal confession of the insufficiency of its past depreciation
charges, by the following unique procedure:

1. Tt reduced the stated value of its common stock by $1,587,000 and
transferred this sum to capital surplus.

2. It immediately used up this capital surplus by charging against it
$1,500,000 for additional depreciation and $87,000 for contingencies.

In this case we see a good part of the necessary depreciation
charge excluded from the income statements over a period of
years and finally allowed for by reducing the amount at which
the common stock is valued. An incidental effect of this mis¬
chievous accounting was to permit the parent company (Ameri¬
can Electric Power Corporation) to take out in dividends a sum
exceeding the true earnings and the initial surplus combined,
to the serious prejudice of the bondholders and the first preferred
stockholders. 1

Inadequate Depreciation Revealed by Transfers from Surplus
and Reserves. — Example: The case of Brooklyn Union Gas is
perhaps the most impressive example of the failure of the income
account to reflect the necessary deductions for amortization.
The extent of the consequent overstatement of earnings has been
glaringly revealed by the huge transfers required to be made
from surplus and contingency reserves. The story may be
summarized as follows, as regards the ten years 1929-1938:

1 For examples of other methods by which depreciation and depiction
charges arc excluded from the income account, and for comment on their
implications, see Appendix Note 52, p. 779.

468

SECURITY ANALYSIS

Brooklyn Union Gas Company

A . Annual average 1929-1938:

Gross revenue. $23,389,000

Depreciation. 729,000

Depreciation, per cent of gross. 3.1

Depreciation, per cent of fixed capital. 0.67

Reported earnings for common. $ 3,791,000

Dividends paid. 2,918,000

Indicated balance to surplus.$ 873,000

B. Ten-year period 1920-1938:

Surplus and contingency reserve, Dec. 31, 1928. $29,161,000

Surplus and contingency reserve, Dec. 31, 1938.. 9,840,000

Decrease for period. 19,321,000

Indicated increase per income account above. 8,730,000

Discrepancy. $28,051,000

Average earnings per share of common per income account. $5.13

Average earnings per share of common per balance sheet.. $1.36

C. Explanation of discrepancy:

Transferred from surplus, etc., to:

Reserve for depreciation or retirements. $25,300,000

Write-off of appraisal expense, 1937. . 1,781,000

Miscellaneous charges (net). 970,000

Total charges to surplus, etc., 1929-1938. 28,051,000

D. Retirement reserve “used up” 1929-1938:

Retirement reserve, Dec. 31, 1928. $ 1,505,000

Additions from income, 1929-1938. ... . 7,290,000*

Additions from surplus and contingency reserve. 25,300,000

Total. 34,155,666

Balance (depreciation reserve), Dec. 31, 1938.. 7,270,000

Reserve consumed by actual retirements.$26,885,000

♦In addition there weic indicated appropriations from income of about $130,000 per
annum for coke-oven rehning and replacement reserves, which in 1938 weie combined with
the depreciation reserve in the balance sheet. If these are regarded as the equivalent of
depreciation, then both the depreciation allowance and the “reservo consumed" would be
increased by about $1 300,000 for the ten-year period.

The foregoing figures are given in considerable detail, since
they disclose a complicated but significant state of affairs bearing
on the true earning power of the company. The reader will
note the following points:

1. The average reported earnings of $5.13 per share were computed after
deduction of a “retirement reserve” of very small size in relation to both
gross earnings and plant account.

2. These charges for retirements against income proved woefully inade¬
quate to cover the actual retirements taking place during the period. To
meet these charges the company had to exhaust a large contingency reserve 1

1 This contingency reserve had itself developed out of an “accrued

ANALYSIS OF THE INCOME ACCOUNT

469

($13,800,000 at the end of 1928) and to draw heavily on surplus
besides.

3. Although the company reported to stockholders that it had earned an
aggregate of $51 per share during the period, paid dividends of $40 and
carried $11 per share to surplus, its surplus and contingency reserve had
really decreased about $26 per share. Hence the earnings as indicated by
the balance sheet had averaged only $1.36 per share instead of $5.13 per
share as reported in the income account. 1

4. The actual retirements of property during this period averaged $2,688,-
000 per annum, or 11% of gross, as compared with the charge to income of
$729,000, or 3.1% of gross. In the year 1938 the company stated that, in
accordance with the new requirements of the Public Service Commission of
New York, it was adopting a depreciation policy, that the details had not
yet been worked out and that provisionally it was charging $1,200,000 per
annum for the purpose. Judging from the facts stated and our previous
discussion, there would seem to be grounds for doubt if even this amount,
although much larger than former charges, is adequate. 2

A Variety of Depreciation Policies. —The foregoing discussion
of failure to reflect full depreciation charges in the income
account leads us into a broader topic, viz., the basis used by a
company in making its depreciation allowance. The methods
employed reveal an extraordinary variety, no less than seven
calling for description, as follows:

A . Depreciation Proper .

1. Straight-line Method .—Each class of depreciable property
is written down to salvage value by equal annual charges during
the period of its estimated life. This is the standard method of
calculating depreciation, permitted by the revenue acts and
generally followed by all companies in their income tax returns.
Surprisingly few electric and gas companies, however, have
employed this method in their published income accounts.

amortization” account which ended in 1916. Since that date the successor
contingency reserve appeared to be equivalent to surplus.

1 If the company is given credit for the increase in the depreciation reserve
at the end of 1938 as compared with Dec. 31, 1928, the indicated adjusted
earnings would average about $2 per share. During most of this period the
company calculated the earnings per share in its annual reports on the basis
of its inadequate retirement allowances and in 1934-1936 also computed
even larger earnings per share, including therein income tied up in rate
litigation, most of which was later returned to customers.

2 Note that the stock sold as high as 248 in 1929, at 129 as late as 1931
and as low as 10 in 1938. In 1939 it advanced to 30 on reported earnings
of $3.07 per share for the 12 months ended June 30. But a depreciation
allowance of 11 % of gross would have reduced the earnings to $1.30 per share.

470

SECURITY ANALYSIS

Example: Union Electric Company of Missouri, a subsidiary
of North American Company, has used the straight-line method
for a number of years. But even here the company's reported
allowance is less than that claimed on its income tax return
($3,899,205 vs. $5,549,109 in 1937) the difference being due
apparently to assuming a shorter life for tax purposes than for
annual report purposes.

As will be pointed out later, recent regulations adopted by
state commissions and by the Federal Power Commission are now
necessitating a change-over by many companies to the straight-
line or standard method in their reported earnings.

2. Sinking-fund Method. —Allowance is here made for the fact
that amounts set aside for depreciation will earn interest until
the property is retired. The effect of this method is to make the
deductions somewhat smaller in the earlier years and correspond¬
ingly higher in the later years. It is generally used by California
utility corporations under agreements with the Railroad Com¬
mission of the state, the rate of interest allowed being 6%.
(Examples: Pacific Gas and Electric, San Diego Consolidated
Gas and Electric.) Even here the companies take the straight-
line basis in their tax returns.

3. The Over-all Method. —This applies a single annual per¬
centage to the entire depreciable property account, instead of
varying rates to different classes of assets. The object, pre¬
sumably, is to arrive at a simple approximation of the actual
depreciation.

Example: Commonwealth Edison deducts 3% of the average
book value of depreciable property.

B. Retirement Reserve Methods. —The distinguishing feature
of a retirement reserve is that it does not seek to measure the
depreciation during a given period caused by wear and tear or
obsolescence. Instead it is supposed to provide funds that, in the
opinion of the management, will be adequate to take care of
retirements of property when and as they occur. Over any
long period of time, proper depreciation and proper retirement
allowances should total the same amount. But a retirement
reserve policy apparently permits arbitrary annual variations,
to reflect good or bad earnings or the expected near term need
for actual retirements. In reality, as will be seen, the majority
of retirement reserve policies operate simply to understate the

ANALYSIS OF THE INCOME ACCOUNT

471

current loss of property value and thus to overstate the earn¬
ings. Various bases of calculating retirement reserves are as
follows:

4. Percentage of Gross .—This method would tend to approxi¬
mate a regular depreciation rate if the percentage taken were
adequate. Generally this is not the case.

Example: Duquesne Lighting Company deducts 8% of gross.
On the other hand, its income tax deduction for 1932-1934
equaled no less than 30% of gross.

5. Fixed Rate per Unit of Product .—This method clearly
resembles the preceding and is subject to the same criticism.

Examples: In 1932 Brooklyn Union Gas Company stated that
it was reserving 3 cents per thousand cubic feet for retirements.
(This policy has since been changed.) Cincinnati Gas and
Electric Company stated in 1937 that it was making provision
for retirement reserve at the rate of 5 cents per thousand cubic
feet of gas sold and $2.70 per thousand kilowatt-hours of elec¬
tricity sold.

6. Over-all Percentage of Gross for Maintenance and Depreciation
Combined .—By this method the larger the amount spent for
maintenance the less is reserved for depreciation. 1

Examples: Third Avenue Railway used a 20% deduction for
maintenance and depreciation combined for the years 1912-
1918. Tidewater Power Company uses varying total rates for
different services, viz. (in 1936): Gas and Electric, 15%; Water,
12%; Railway, 30%.

7. Discretionary Deductions .—The majority of companies
following the retirement reserve method have been bound by no
mathematical formula but have based the annual deduction
largely on the judgment of the management.

Examples: a. Amounts varying year by year: Detroit Edison,
Philadelphia Electric, American Water Works and Electric,
American Power and Light.

b. Unchanged annual round amount: Tampa Electric charged
$430,000 per annum from 1933 through 1939.

1 Although this policy is not generally followed by companies in their
own accounting, it is frequently met in the minimum requirements imposed
by bond indentures and also in those imposed by the S.E.C. as a condition
to the approval of new bond issues under the Public Utility Holding Com¬
pany Act of 1935.

472

SECURITY ANALYSIS

c. Allowance made equal to actual retirements during year:
Western Union Telegraph Company in 1932-1936. The deprecia¬
tion charge of $5,631,000 in its income account for 1936 compares
with a provision of $11,190,000 in the tax return. The differ¬
ence would account for most of the $7,199,000 reported as
earned for the common stock that year. The inadequacy of
past allowances for depreciation was shown by the transfer in
1937 of $30,000,000 from surplus to depreciation reserve.

Double Accounting Policies on Depreciation. —We have already
stated that, regardless of what method is followed in the annual
reports, practically every company follows the straight-line basis
of depreciation in computing its income tax. 1 The investor is
thus confronted with a dual situation and a pressing problem.
In many cases it is of vital importance to know which basis of
depreciation is correct, since bond-interest coverage and com¬
mon-stock earnings which may appear adequate as reported
in the company’s annual statements would turn out to be entirely
insufficient if the income tax figures are accepted.

Example: The existence of this disparity was unknown to
investors generally until brought out into the open in one of the
first prospectuses published under the terms of the 1933 act,
viz., that describing the American Water Works and Electric
Company Convertible 5s, due 1944. This document revealed
that in 1932 “tax-return amortization” had been taken at
$7,023,000, as against “income-account amortization” of only
$2,747,000. At that time there was a tendency in Wall Street
to minimize the significance of these divergences, on the ground
that depreciation was a highly technical and controversial matter
and there was just as much reason to accept the income-account
basis as the tax-return basis.

Reasons for Accepting , in General , the Income Tax Base .—We
have always been convinced that this heedlessness was danger¬
ously unsound. Developments since 1934 have strongly but¬
tressed our opinion, so that we now can advance no less than five
major reasons for accepting, in general, the income tax figure
rather than the income-account basis of depreciation. These are:

1 Prior to 1934 Consolidated Edison apparently used the same retirement
allowance in tax returns and annual reports, but has since taken advantage
of the higher depreciation rates in calculating its tax. Interim reports for
1939 suggest a swing back to the former practice.

ANALYSIS OF THE INCOME ACCOUNT

473

1. The straight-line basis follows a definite and logical accounting theory.
If it resulted in an excessive deduction the Treasury Department would not
accept it. The various retirement-reserve bases are either entirely arbitrary
or technically unsound.

2. The inadequacy of the “retirement reserve” idea in general has been
shown by the necessity in many cases of making large transfers from surplus
to bolster the retirement account. Example: See Brooklyn Union Gas
exhibit on pages 4G8-4G9.

3. Since 1934 there has been an almost universal increase in the retirement
allowances—both absolutely and percentagewise. This may be considered
a virtual confession of past inadequacy. The extent of these increases is
indicated by our table on page 474, which supplies information concerning
depreciation or retirement allowances, as well as maintenance charges,
covering the years 1930 and 1938 for a number of utility companies. It is
to be noted that in the earlier year the companies using the retirement basis
generally made lower charges than those using the depreciation basis.
Observe, also, that a number of the companies previously using the retire¬
ment method have since switched to a depreciation basis. Moreover, a
considerable number of the companies that used the retirement basis in
1938 were on the verge of a transfer to a depreciation basis under the impetus
of requirements of the Federal Tower Commission and of various state
commissions.

4. A number of state commissions and the Federal Power Commission
have now ordered companies within their jurisdictions to follow a regular
depreciation basis in all their accounts.

Examples: Pennsylvania, Michigan and New York. 1 Some important
companies are perforce switching over to the income tax basis in their annual
statements. For example, Consolidated Edison Company of New York
for the calendar year 1933 charged $18,829,000 for retirement reserve in its
report to shareholders and charged about $26,800,000 for depreciation on a
straight-line basis in its income tax return. For the 12 months ending
September 30, 1939, the company charged $24,217,000 for depreciation in
its interim report to shareholders as against a charge of only $17,737,000
in its report for the corresponding period ending September 30, 1938.
Gross operating revenues for the latter two periods were $24S,6G6,000 and
$239,413,000, respectively.

5. Where any real alternative exists, the investor in fixed-value securities
must invariably apply the more stringent test of soundness.

1 After endeavoring in 1934 to impose a strict straight-line depreciation
policy upon New York utilities and having met with reversals in court, the
New York Public Service Commission promulgated a new rule which requires
each utility company to record the estimated amount of depreciation accrued
each month. Depreciation is defined as “the net loss in service value not
restored by current maintenance, incurred in connection with the consump¬
tion or prospective retirement of plant in the course of service from causes
which are known to be in current operation and against which the utility
is not protected by insurance.” This is undoubtedly a move in the direction
of straight-line depreciation accounting.

Comparative Depreciation or Retirement Allowances of Public Utilities, 1930 and 1938

474

SECURITY ANALYSIS

1938

Ratic of year’s
depreciation
or retirement

reserve to aver¬
age property
account, %

Ratio of
mainte¬
nance
to gross,

(O^OMiO^OONiO^iON oOi/JiOHH^HNOOOOHOPln CO
^CON^^tOOtQtOOOVu: •NWr-‘0>0t-<0tDv0'^'^l£>(0C)©N t>.

Mainte¬

nance

(000

omitted)

$ 760

1,669
3,828
1,841
4,604
7,515
3,587
4,155
3,979
10,695
6,005
7,915
?

2,314

1,771

3,759

5,930

1,767

6,006

9,562

1,218

2,247

1,653

4,738

16,328

1,514

4,956

8,139

2,847

1,656

Ratio of
D or R

to gross,
%

MQUJ©<HOOOO<00<-<XHt«)OONlO©t-<»0©CO>QOODnnMiOOC4
'D'NM V^NO^OOOOMOOOOfflOOOCOO^Ot-ONrHMffiNOSlO

Deprecia¬
tion D or
retirement

reserve R
(000

omitted)

Q Q Q C|

rtiOHUJ^COaONiO’if Oi«©®M03^iOW©OOWMO>>ONW VOO
Nu5b-Ml'P--‘QlN00U5©-HTf0>»O>-i^O©NT|«O>C5N'-if-0r. CC t- ©
P5t-MWrtfflN©>OWOOOOCJOt-NCO'*'NOWO©uOC»OiOC CO N

csi ^ <© -r ^ ©" © © © to c7 po o» oo rC © vwoicono^<n>o>-i

•»

Gross

j l

$ 16,365

45.501
54,813
42,997

101,425

116,572

52,716

72.502
61,217

126,821
92,968
139,545
104,233
30,072
35,616
50,004
107,249
34,557
84,686
145,915
20,038
39,648
41,390
96,884
240,S96
24,938
82.371
129,323
39,237
59,809
22,4S9

1930

Ratio of year’s
depreciation
or retirement

reserve to aver¬
age property
account, %

N^rtiOr-ON^Oai-^^OO^-Hrt^NfMOOCOtDOiMrHSNNlC©

COMCO^HMHHHrHHNOrtHHHHHONHHOHHOOOOO

Ratio of
mainte-

nance
to gross,
%

• -OOJO ■ *0 -MM • • -anOlMOl • -ICN • ■ 0» • Oi

• ©N© © .t-OJ • ■’ ■ ■>* © r- © ^ •©© •’ • t- o> • »t«-

Mainte¬

nance

% T

3.199
1,1S0
3,796

3,446

3,321
12,SSI

1,410

1,778

4,252

5,586

1,3S9

1.199
2,013

17,047

3,628

2,464

2,034

Ratio of
D or R

to gross,

O0>CCN©NN©©©©©MON®'9(MC<5OC»«i0>d ( MOO(»C0^©

rtHHHrt2® 0005C06000 ®® NNNNN ' D<D<D<D<0 ' 0<i:> ' 0,,5 ' < '' < ' N

Deprecia¬
tion D or
retirement

reserve R
(000

omitted)

Q q ft* q Q q os q aj Ci as a* a* ft* a; as eg a? as as q ft; as as as as os a; os os as

©■^©^©^©(/jO^QOO'O^QkOOWtHMrHQTfCcOCnwaQNa

«COQrt(OSOO)NOMO©01®0'9 | NO'9'l>0©©nM'(J'fOn©

ONO)0»M®CCO)0)^H««Wr-OOOi©N^©©0(NNCr>>0^®

Cq©OXJ0C')'9'©n'HWs'©MN'«iMN©0>HWN©©ei'9'’9'i-<P5
«* *"* *"' . y~<

omitted)

'r00NacO»HW^'9tMO^ , »®(NN'<f(M©W©»O'-'00cr)M'l<Oi®®0r)
OMOMNi0 5Q'H®C0Q^'NN©f-«)N«5^OC000ifteiC9’-<Qi5O
©i»l’.HiONO©V'H'-iOOfflNO«©CON^^»ONHJO(MO®0

■9'00«'-<tOc0M0Cl®00©'irWWM^ | 00(«©I-'(»>'5O»N(»l-'/i'«1<'-iCCi0
^-f»»i»0'<ri’-c^ir3«09rcooiCOt-C'je»9»coc-ioOMi-Hcocoooeocoi-«.coi-<N
^ r-. <N

Company

Kansas City Power A Light Co.

Pacific Lighting Corp.

Detroit Edison Co .

Southern California Edison Co.

Pacific Gas A Electric Co .

North American Co .

Engineers Public Service Co.

American Gas & Electric Co .

International Hydro-Electric System_

Public Service Corp. of N. J .

Columbia Gas A Electric Corp.

Commonwealth Edison Co .

Electric Power A Light Corp.

Duquesne Light Co ....

Northern States Power Co. (Del)
American Water Works A Electric Co...
United Gas Improvement Co . .

Consolidated Gas, etc., of Baltimore_

National Power A Light Co ....

Commonwealth A Southern Corp ....

Detroit City Gas Co.t ...

Public Service Co. of Northern Ill.

Peoples Gas Light A Coke Co . .

American Power A Light Co .

Consolidated Edison Co. (N. Y.)....

Illinois Power A Light Corp.§ .

Niagara Hudson Power Corp.

Associated Ga3 A Electric Co .

Penna. Power A Light Co . .

American A Foreign Power Co ...

Brooklyn Umon Gas Co .

* See 1939 figures on p. 473. f This figure includes depletion, t Now Michigan Consolidated Gas Company. § Xow Illinois Iowa Power Company.

ANALYSIS OF THE INCOME ACCOUNT

475

Examples: The practical significance of our fifth reason is shown by two
examples—one current as this is written, the other taken from the securities
market of 1930.

Item

Pennsylvania
Power <fc Light

Southern California
Edison Co. (added
for comparison)

Results for year ended June 30, 1939

Gross.

$39,232,000

$44,421,000

Depreciation.

2,815,000

6,872,000

Percentage of gross.

7.2%

15.5%

Balance for charges.

13,985,000

19,349,000

Charges and pfd. dividends.

10,171,000

11,891,000

Times earned.

1.38 times

1.63 times

Balance for common.

3,814,000

7,458,000

Price of pfd. stock July 1939.. . .

95 for $5 div. issue

29 for $1.50 div. issue

Yield on pfd.

Depreciation on income tax basis

5.26%

5.17%

(1938) .

4,947,000

Percentage of gross.

Charges and preferred)

12.6%

dividends earned, >.

income tax basis )

1.17 times

It is difficult to understand from the foregoing figures how the investor
could justify to himself the purchase of Pennsylvania Power and Light $5
Preferred at a price to yield only 5.26%. On the basis of the company's
own report the margin above fixed charges and preferred dividends was
entirely inadequate; on the income tax basis for depreciation this is cut by
more than half; on the basis of the percentage of gross applied by Southern
California Edison, the margin practically disappears.

If we examine a very similar situation existing in 1930, as shown in the
table on p. 476, we shall see how important it was for the investor to
recognize the implication of the figures.

In this case we had three factors that militated against the investment
merit of American Power and Light Preferred Stock: (1) The coverage as
stated was entirely insufficient for real safety. (2) The depreciation rate
taken was far too low. An adjustment to the Pacific Lighting basis would
have sharply reduced the margin above preferred requirements. (3) These
requirements were temporarily understated by about $2,000,000, because a
large preferred issue was then entitled to only $3 in dividends, the rate
advancing gradually to $5 in 1933.

The decline in the market price of the $6 preferred in 1938 was due to
reductions in the dividend beginning in 1933, brought about in turn by

476

SECURITY ANALYSIS

lower net earnings which absorbed the small margin above preferred require¬
ments existing in 1929. Recovery in reported earnings after 1933 was held
back, in part, by the necessity of stepping up the depreciation allowance
gradually to bring it in line with realities.

Item

American Power
& Light

Pacific Lighting
(added for com¬
parison)

Results for calendar year 1929

Gross.

$88,222,000

$43,275,000

Depreciation. .

5,317,000

5,525,000

Percentage of gross.. . .

6.0%

]2.9%

Balance for charges. .

44,349,000

14,257,000

Fixed charges and pfd. dividends.

32,762,000

7,623,000

Times earned.

1.36 times

1.87 times

Balance for common.

11,587,000

6,634,000

High price of $6 pfd. in 1930.

107

106

Low price in 1938.

Instances When Income Tax Basis Should Be Rejected or
Questioned .—The reader may note that we have counseled
acceptance of the income tax basis “in general.” The suggestion
is qualified because there may at times be reasons cither to accept
the annual report figures or even to seek a third basis of
amortization.

The Pacific Lighting case, used for comparison in the last
example, illustrates our first exception. The figures for 1929
were taken from the annual report and are based on the “sink¬
ing-fund” depreciation method generally followed by agreement
between the California Commission and California utility com¬
panies. It appears that the deductions for depreciation taken
by the company average lower than the straight-line deduction
taken on the tax returns. Nevertheless, in this case the com¬
pany’s reported figures might well be accepted, first, because
they result from applying an admissible accounting method and,
second, because the amounts appear to be liberal in relation
both to the property account and to the gross earnings. The
same reasoning would apply to all the California utilities.

There is another large group of companies that have taken
depreciation allowances that appear liberal in themselves but

ANALYSIS OF THE INCOME ACCOUNT

477

are still substantially less than the income tax deductions.
Examples: In 1938 Detroit Edison charged 13.5% of gross on
its report to shareholders, vs. 18.2% of gross on its tax return
for that year. Corresponding figures for North American Com¬
pany for 1937 were 12.8 and 14.8%, respectively.

In these instances the investor—and particularly the common-
stock buyer—may argue that the income tax basis is unduly
severe. It is difficult to pronounce judgment on this point in
the absence of detailed knowledge of the properties themselves
and a better familiarity with public-utility engineering details
than we possess. We are inclined to advance the compromise
suggestion that when the tax figure exceeds, say, 12)^% of gross,
the latter rate be used provisionally for purposes of analysis. 1
It may be pointed out that several years ago it appeared that
10 to 12% of gross constituted a comparatively liberal deduction.

Practical Effect of Varying Depreciation Policies.—The reader
may consider this discussion of utility depreciation policies
to be highly technical and uninteresting, but the fact remains
that it has a bearing of the greatest practical importance on
the selection of public-utility stocks and on their market behavior.
The companies that charged inadequate depreciation prior to
1934 were generally overvalued in the stock market, because
investors gave equally inadequate attention to this point. A
careful analyst would have found many occasions to suggest

1 The 12K % rate fo about midway between the average figure taken by
companies on their tax returns and on their reports to shareholders and is
fairly close to the average depreciation rate on the sinking-fund basis as
currently reported. A study published by Goodbody and Company,
members of the New York Stock Exchange, in May 1938, which covered
about two-thirds of the light and power industry, indicated that the industry
as a whole had deducted 10.40% of gross for depreciation or retirements in
its reports to stockholders for the year 1937 and had claimed 14.78% of
gross for depreciation on its tax returns. A detailed computation published
by the S.E.C. in July 1939, covering 177 operating gas and electric utilities
in holding-company systems, showed that for 1938 the depreciation or
retirement allowances taken in their income accounts averaged 10.30% of
gross operating revenues. A study by the Federal Power Commission of
the 1937 results for 385 utilities, representing 90% of the electric utility
industry as measured by assets, showed an average depreciation charge of
10% of electric utility operating revenues and 9.2% of total utility operating
revenues. See Statistics of Electric Utilities for the Year Ended December 31,
1937, Vols. I and II. 1939.

478

SECURITY ANALYSIS

transfers from less conservative to more conservative companies.
Since in the following years there has been a tendency for the
former group to step up their charges substantially, their reported
earnings have been correspondingly held down, and their market
prices also. The following example will illustrate this
development:

Example:

American Water Works and Electric vs. Pacific Gas and Electric 1

Average 5 years

Year ended June

Item

Gross earnings.

Depreciation..

Percentage of gross.

Available for fixed charges.

Interest and preferred dividends....

Balance for common.

Earned per share.

Earned per share adjusted 2 .

Average price

1927-1932

30, 1939

Airier.
Water
Works
& El.

Pacific
Gas &
El.

Amer.
Water
Works
& El.

Pacific
Gas &
El.

$50,200

3,665

7.3%

20,998

16,290

4,708

2.69

1.47

$72,175

8,330

11.6%

30,717

18,7S5

11,932

2.67

$51,791
5,278
10 2%
17,898
16,768
1,130
0.48
dcf.

$104,529
14,679
14 0%
37,416
20,198
17,218
2.75
2.75

Year 1933

July 1939

23K

10 x

31«

1 Dollar figures are in thousands, except those per share.

* Allowing for depreciation at per cent of gross taken by Pacific Gas and Electric.

The price of American Water Works common in 1933 was
apparently based on the reported earnings for previous years,
without allowance for the fact that the retirement allowance
was definitely inadequate. A good part of the decline in the
amount available for the common seven years later was due to
the necessity for increasing the retirement allowance in line
with the general tendency.

The Pacific Gas and Electric exhibit is appended to demonstrate
that the public-utility stock buyer could have obtained much
more for his money in 1933 had he been willing to scrutinize
depreciation policies with care.

CHAPTER XXXVI

AMORTIZATION CHARGES FROM THE INVESTOR’S
STANDPOINT

We have already made several references to the point that a
depreciation or depletion charge that is technically proper from
the accounting standpoint may fail to reflect the situation prop¬
erly as it concerns the buyer of the company’s stock at a given
price.

Problem Indicated by Hypothetical Example.—The point at
issue may be more readily comprehended by the use at the
outset of a simplified and therefore hypothetical example.

Let us assume that companies A, B and C are all engaged in
the trucking business. Each has a single truck; each is capital¬
ized at 100 shares of stock, no par, and each earns $2,000 per
annum before depreciation.

Company A paid $10,000 for its truck.

Company B paid $5,000 for its truck.

Company C paid $5,000 for its truck but followed “an ultra conservative
policy” and wrote its value down to $1.

Assume that A’s purchase of a dearer truck was an accident
and that in fact the managements of the three companies are
equally, capable and their general situation dentical.

The accountants give these trucks a depreciable life of four
years. On this basis the income accounts of the three corpora¬
tions are as follows:

Item

Company A

Company B

| Company C

Net before depreciation.

$2,000

2,500

$2,000

1,250

$2,000

Depreciation (at 25%).

Balance for common stock.

Earned per share.

600(d)

750

$7.50

2,000

$20

Typical Market Appraisals .—According to these audited state¬
ments, A is losing money, B is earning 15% on its capital and C is
doing very well indeed. An “investor,” steeped in the recent

479

480

SECURITY ANALYSIS

wisdom of stock-exchange valuations, would consider the shares
of Company A practically worthless—$5 per share, perhaps,
being a generous appraisal. On the other hand he might value
the shares of B and C at about ten times the earnings, which
would produce $75 per share for B stock and no less than $200
per share for C stock. Such a procedure would result in the
following total valuations for the three enterprises:

Company A . $ 500

Company B . 7,500

Company C . 20,000

The absurdity of these valuations should be too patent for
argument. Nevertheless they represent merely a faithful appli¬
cation of current accounting methods and the established Wall
Street reasoning. The results are, first, that a company with a
less valuable asset is for that very reason declared to be worth
more than a company with a more valuable asset; and, second,
that by the single gesture of writing down its assets to zero, a
company has been able to increase enormously the market price
of its shares.

Irrationality of These Valuations Disclosed by the Balance
Sheet. —The irrationality of these conclusions would be even
more glaring if the balance sheets are examined. Assume that
the companies have been in business three years and (for simplic¬
ity) that they started with no working capital. Company A,
having lost money steadily, has of course paid no dividends;
Company B has paid out two-thirds of its earnings, i.e. $5 per
share annually, and Company C has paid out three-fourths of
its profits, or $15 per share. The balance sheets would then read
as shown in the table on page 481.

Although Company A has a profit-and-loss deficit, it has
accumulated the largest amount of cash, presumably “ear¬
marked” as a depreciation fund. Company C, which has shown
the largest earnings, has by far the smallest cash holdings. The
suggested market value of $5 per share for Company A would
amount to only one-twelfth of its cash, whereas the price of $200
for Company C shares would equal more than twelve times the
cash behind them.

A More Rational Approach. —These are the Alice-in-Wonder-
land results to which the accepted logic of the stock market

ANALYSIS OF THE INCOME ACCOUNT

481

would lead us. Let us now ask a more sensible question, viz.,
“How would a business man determine the reasonable value of
these three enterprises?” Common sense would tell him imme¬
diately that all three businesses a$ such, independent of their
assets, are of equal value. As a practical business matter he
would be inclined to place a somewhat higher valuation on the
more expensive vehicle owned by Company A than upon the
cheaper truck of Companies B and C . Nor is there the slightest
doubt that this business man will give full weight to the relative
cash holdings of each company.

Item

Company A

Company B

Company C

Assets:

Truck.

$10,000

$5,000

$ i

Cash.

6,000

4,500

1,500

Total.

516,000

$9,500

$1,501

Liabilities:

Capital stock.

$10,000

$5,000

$ 1

Depreciation reserve.

7,500

3,750

Profit and loss.

1,500(d)

750

1,500

Total.

$16,000

$9,500

$1,501

His reasoning would therefore run somewhat as follows: Each
business is worth, in the first instance, the amount of its cash
plus the fair market value of its truck. Something might
properly be paid also for the good-will, because the earnings on
the average capital required for the business, after allowing for
necessanj depreciation , would be quite substantial. This good¬
will value would be the same for all three enterprises.

Item

Company A

Company B

Company C

Cash.

$4,500

1,000

2,000

$1,500

1,000

2,000

Truck (estimated).

Good-will (estimated).

Total value.

$9,500

$7,500

$4,500

What is the relation of the companies 1 depreciation charges
to these valuations? The answer is that the charge made by

482

SECURITY ANALYSIS

Company B might well be accepted as relevant because it corre¬
sponds fairly well with the conditions of the business. Partly by
coincidence, this fact results in making the business-man's valu¬
ation of Company B identical with that reached by the Wall
Street method. But in the case of Company A and Company C,
the depreciation charges made by the managements arc entirely
out of line with the realities of the business. In the one case
they have been made far too high because of the excessive cost
of the fixed assets. Such an error should be corrected by writing
down the property account (and the capital account) to a fair
going-value, against which a businesslike depreciation charge
will accrue. In the case of Company C the assets have been
deliberately undervalued for the purpose of suppressing a depre¬
ciation charge that mast be allowed for out of earnings because
the owner's investment is actually depreciating. If the business
man or the investor is going to pay anything for the truck (or
for the business itself that requires a truck), he cannot avoid
allowing for depreciation on the amount so paid by merely
making believe that there is no such investment.

Practical Application of Foregoing Reasoning.—Let us consider
now how the foregoing reasoning may be applied to actual situa¬
tions that confront the security buyer.

Examples: As an initial example, we shall present the exhibit
of the Eureka Pipe Line Company for the three years 1924-1926.

Year

Gross

revenues

Net before
deprecia¬
tion

Depre¬

ciation

Balance
for stock

1924

$1,999,000

$300,000

$314,000

$ 14 , 000 (d)

1925

2,102,000

541,000

498,000

43,000

1926

1,982,000

486,000

500,000

14 ,ooo(d)

3-year average.

Per share of common

2,028,000

442,000

437,000

5,000

(on 50,000 shares) .

$8.84

$S 74

$0.10

The final column would imply that during the three years under
review there was practically no earning power for the shares,
so that presumably the stock would have no value on a going-
concern basis. But would such a conclusion be justified from a
business standpoint? The question will turn, as in our hypo-

ANALYSIS OF THE INCOME ACCOUNT

483

thetical examples, upon the correctness of the depreciation
charges. The following data will throw additional light upon this
aspect of the Eureka Pipe Line’s record (figures in thousands):

Year

Pepi c-
ciation
chaiged
for yeai 1

Actually
expended
for plant
replace¬
ments,
etc.

Depre¬

ciation

chaige

unspent

Earn¬

ings

after

depre¬

ciation

Sur¬

plus

adjust¬

ments

Total

cash

avail¬

able

from

year’s

opera¬

tions

Divi¬

dend

paid

Added
to net
quick
assets

1924

S314

$ 75

$239

314(d)

cr. $38

$263

$350

$87(d)

1925

498

cr. 51

549

dr. 43

549

200

349

1926

500

194

306

14(d)

292

200

3-year average

407

365

dr. 2

368

250

118

We find that the expenditures on property account averaged
only $73,000 per annum, so that there was available in actual
cash the sum of $368,000 per annum to be added to working
capital or used for dividends (which were charged against previ¬
ously accumulated surplus). It is clear that this business had
been a producer of cash income for the owners, and for that
reason it had substantial going-concern value, although the high
depreciation charges made it appear that there was none.

How to Determine the Proper Depreciation Charge. —In this
case, therefore, as in our hypothetical example, the investor or
the analyst must reject the company’s basis for depreciation and
endeavor to establish some other basis more consonant with the
actual conditions of the business. How can the proper charge
be determined? The answer was given without difficulty for the
trucking companies, because we knew just what depreciation
had to be allowed for in order to maintain these enterprises in
operation. But in practice such exact knowledge is hardly ever
available. We do not know how long the Eureka Pipe Line’s
fixed assets will last or how much it would cost to replace them.
The best we can do is to formulate some rough estimates based
on the discoverable facts. The only virtue of these estimates
may be that they are in all probability closer to the mark than
the company’s figures, which we realize are untenable.

Concept of “Expended Depreciation.” —Taking a business
attitude towards the Eureka Pipe Line’s exhibit, it is evident at

484

SECURITY ANALYSIS

the start that the depreciation allowance should be not less than
the average expenditures made on the property. The primary
reason for reducing the company’s depreciation charges is that
they do not properly reflect the cash available from operations.
The expenditures on property account, including new fixed
assets, represent in effect the portion of the depreciation reserve
that is not available in cash, and that portion should hence be
considered as the minimum amount of depreciation that must
be allowed for in conducting the business. We may call this
item the Expended Depreciation Charge . (If the increase in the
property account exceeds the year’s depreciation, then all of
the latter must be considered as “expended.”) In the case of
Eureka Pipe Line, such expenditures averaged $73,000 for the
three years 1924-1926. This period is much too short upon
which to base conclusions. But it happens that about the same
results are shown by Eureka over a much longer period, so that
the 1924-1926 figure may here be used as a basis of calculation. 1
We must warn the student against deriving any notion as to the
normal expended depreciation from examination of a short
period, e.g., less than ten years, unless he knows that the nature
of the business is such as to warrant a conclusion therefrom.

Long-term Depreciation a Form of Obsolescence. —The second
question is what amount should be provided as a reserve to
take care of the eventual wearing out of the entire property—
in other words, for the major replacements that may have to
be made at some distant date. This is the leading function of
the depreciation charge in most theoretical discussions of the
subject, and our trucking company examples were based on
a simple application of this idea (the total fixed-asset account
having to be replaced at the end of four years). But we must
recognize that in practice such complete wearing-out and replace-

1 The “expended depreciation” is calculated as follows: Deduct from the
year's depreciation charge the year's decrease in net plant account (plant less
depreciation on the balance sheet).

Example: Eureka Pipe Line net plant account, Dec. 31,

1923 . $6,122,000

1924 . 5,883,000

(1) Net decrease. $ 239,000

(2) Depreciation charge, 1924.$ 314,000

Expended depreciation: (2) minus (1) = % 75,000

ANALYSIS OF THE INCOME ACCOUNT

485

ment are of exceedingly rare occurrence. The typical corpora¬
tion does not accumulate a large cash fund over a stretch of years
which is finally employed to replace the plant in its entirety at
the end of its useful life. Factories do not actually wear out;
they become obsolete. In nine cases out of ten, plants are given
up because of changes in the character of the industry or in the
status of the corporation or in the locality where the plant is
situated or for other reasons not related to actual depreciation.

These developments represent business hazards , the extent of
which is not susceptible of any engineering or accounting measure¬
ment. Stated differently, the bug-term depreciation factor is in
reality overshadowed and absorbed by the obsolescence hazard. 1
This risk is essentially an investment problem and not an account¬
ing problem. It should not operate to reduce the earnings (as
does a depreciation charge) but rather to reduce the price to be
paid for an earning power subject to such a business risk.

Application of Foregoing in Determining Earning Power .—Let
us endeavor to relate these conclusions to the Eureka Pipe Line
example. The Expended Depreciation Charge has been found
to average about $75,000 per annum. There arc no indications
that the entire plant will have to be replaced at any predictable
date. On the contrary, the line appears to have an indefinite life,
due to continuous expenditures on maintenance, repairs and
renewals. In this respect the enterprise resembles a railroad
far more than it does a trucking company. According to our
reasoning only the expended depreciation charge should be
deducted from earnings. The remainder of the depreciation
factor is actually the obsolescence hazard , which is related to the
possible exhaustion of the tributary oil fields. This should be
considered after the earnings are arrived at and not before. A
proper statement of the case would appear as follows:

1 Companies rarely make special provision in their accounts for obsoles¬
cence. The income tax law permits an obsolescence deduction only after a
definitely ascertainable loss of value from this cause has taken place. In a
few instances the amortization charge is labeled in the income account
“Depreciation (Depletion) and Obsolescence. ,, Example: Allied Chemical
and Dye Corporation.

For a special allowance for obsolescence, made out of earnings because
of a specific development, sec the Southern Pacific Golden Gate Ferries,
Ltd., reports in 1934-1936. Construction of the San Francisco bridges was
expected to make the ferries largely obsolete at the end of 1936.

486

SECURITY ANALYSIS

Etjreka Pipe Line (1924-1926 Basis)

Item

Total

Per share

Earnings before depreciation.

$442,000

75,000

$8.84

1.50

Expended depreciation charge, estimated.

Balance: Earning Power, subject to business
hazards, including obsolescence.

$307,000

$7.34

Problem of Valuing the Earning Power .—The company's
figures showed no earning power for the period. Our figures show
an earning power of over $7 per share, which clearly indicates
substantial value for the enterprise. The price that may properly
be paid for this earning power is subject to whatever considera¬
tions enter into buying a going business. This includes on the
one hand the possibilities of increased profit and, on the other
hand, all the multitudinous risks of loss, of which obsolescence
of the fixed assets is only one. If, for example, it seemed con¬
servative to require earnings of 20% on the investment to cover
these hazards adequately, then the indicated value of Eureka
Pipe Line stock on the above showing would be about $35 per
share. A detailed discussion of this point must be postponed,
however, until we reach the topic of valuation of common stocks.
For the purpose of this chapter it should suffice to point out that
in the actual case of Eureka Pipe Line, as in the hypothetical
case of Trucking Company A , it was both necessary and feasible
for the investor to establish a depreciation allowance significantly
different from that employed by the company itself. 1

Depreciation on Apartment and Office Buildings.—In actual
investment practice the foregoing reasoning finds its widest
application in the field of real estate securities. What is the
true function of the depreciation charge in the analysis of the
numerous bond issues secured by a lien on apartments or office
buildings? Clearly the deduction for depreciation is an account¬
ing rather than an investment calculation. It is based on the
assumption that the original cost is being used up by wear and

1 That the official depreciation charges could stand revision in this case is
evident from the fact that the corporation itself made several quite arbi¬
trary changes in its methods of computation from year to year. In 1929,
for example, the depreciation allowance was suddenly cut to $176,000.
(Data given in reports to the Interstate Commerce Commission.)

ANALYSIS OF THE INCOME ACCOUNT

487

tear in equal morsels over, typically, a fifty-year period. But it
would be an extremely rare coincidence for this arithmetic to
correspond to the investment facts. Buildings of steel and stone
do not actually wear out in fifty years. They become obsolete
and are torn down, after a life that depends for its length not on
wear and tear but on real estate conditions. Furthermore, in
the case of the huge number of real estate bonds that can be
bought at large discounts from face value, the investor’s write-off
for both depreciation and obsolescence would be based on a cost
to him much lower than the book value which is subject to the
conventional depreciation. The concept of “ expended depre¬
ciation” may be useful in this field, because the average expendi¬
tures for replacements must be considered as the equivalent of a
cash operating expense. (Parenthetically it may be pointed
out this is an important factor in the analysis of hotel bonds.
But it is even more important to warn the investor that hotel
bonds should be viewed as obligations of a special type of business
enterprise and not as a form of real estate security.)

Example: A brief analysis of the first-mortgage bonds of 1088
Park Avenue Corporation, owning a large apartment building
in New York City, will illustrate the points that we have been
making.

There are $1,851,000 of this issue outstanding bearing fixed
interest of 2 Yi.% and contingent interest, depending on the
amount of bonds retired, up to 2^4% additional. All the stock
of the corporation is attached to the bond issue. The average
price in 1039 was about 35. Total market value of all securities,
$653,000.

Condensed Income Account for Year Knded February 28, 1939

Gross income. 8251,900

Operating expenses . 101,300

Real estate taxes (assessed value—82,150,000) . 63,000

Depreciation (2% on 82,560,000, book-value of

building) . 51,000

Balance for interest. 33,600

Earned on bonds before depreciation. 4.57%

Earned on bonds after depreciation. 1.82

The maximum permissible annual allowance for
capital expenditures is 6% of gross, or about
$15,000. The only provision for such expendi¬
tures actually made since 1934 was $7000 reserved
in the February 1939 year.

488

SECURITY ANALYSIS

Our analysis would suggest the following:

1. Assuming that 1938 revenues and expenditures are representative of
the future and also that the reserve for capital expenditures made in that
year is representative, there would be an indicated cash income for the bonds
of $84,600 less $7000 or $77,600. This would be 4.3% of par and 11.9% of
the market price.

2. This percentage must be taken not only as applicable to a return on
the investment but also as an allowance for the obsolescence accruing against
the building, which was constructed in 1925. But this obsolescence is
governed not only by age but also by changes in character of neighborhood,
building styles, etc.—factors that arc almost indistinguishable from general
business risks.

3. The investor may assume that out of the ample cash income he will
receive fixed interest of 2% % of par, or 7.86 % of the market price. The
balance, amounting to 4 % of the market price, will be used by the company
partly as a sinking fund to reduce the bond issue and partly for additional
interest. What this really means is that the loss of value through obsoles¬
cence will be offset by cutting down the debt. The investor's judgment
must decide whether or not (a) the interest return is attractive as compared
with the chances both of higher and of lower net earnings and (6) the sinking-
fund operations will amply take care of the obsolescence factor. If his
answer is decidedly “yes,'' he would be warranted in regarding the issue
as an attractive investment—not in spite of its low price but because of its
low price. 1

4. There is the possibility that obsolescence may be offset by appreciation
due to a rise in real estate values—cyclical, secular or inflationary. Reli¬
ance on such appreciation in the past has led many investors to ignore
depreciation and obsolescence in their real estate purchases. We suggest
that such possibilities must be viewed as speculative, that they do not cancel
obsolescence but merely offer an offsetting attraction, and that an investment
commitment in the bonds must be justified without including any such rosy
expectation.

Inadequate Allowances for Depreciation.—Let us now consider
examples involving the opposite type of situation, viz,, the use
of accounting methods by corporations that give rise to inade-

1 A short cut to this possible conclusion could be availed of if the investor
could satisfy himself that a savings bank or insurance company would be
willing to lend more than the market value of the bond issue, in the form of
an “institutional first mortgage” at a low interest rate. If so, the present
bond issue, carrying the common stock attached and representing the entire
ownership of the property, must necessarily be worth more than a shrewd
mortgagee would lend against it. But this quick conclusion must assume
that the institution will make as careful allowance for obsolescence and other
business factors as the buyer of the present bonds at a discount.

ANALYSIS OF THE INCOME ACCOUNT

489

quate allowances for depreciation. Particular attention must be
given to the vogue for drastic write-offs of fixed assets for the
admitted purposes of reducing the depreciation charges and
thereby increasing the reported earnings. This practice had its
inception during the 1927-1929 boom, but its widest development
took place in the ensuing depression. Two typical cases are
selected for discussion.

Effect of Writing Down Fixed Assets
(Unit SI,000)

Safety Car Ileat-

U.S. Industrial

ing&Lighting Co.

Alcohol Co.

Item

Before

After

Before

After

write-

downs

Plant account.

$ 0,578

$9,578

$29,116

Less depreciation.

G,SG2

9,577

9,815

29,115

Plant account (net).

$ 2,716

$ 1

$19,301

$ 1

Intangible and misc. abbots (not).

5,01G

167

1,185

Investments in affiliates, etc.

2,330

1,416

Net current assets.

4,379

6,891

Total.

$14,441

$6,877

$28,793

3 9,493

Capital.

$ 9,862*

$4,931f

$22,585f

3 3,739

Surplus.

4,3G2

1,729 |

4,458

4,004

Contingency reserve.

217

1,750

Total.

314,441

SO,877

S2S,703

3 9,493

* 98,620 shares par $100.
t 98,620 shares, no par.

X 373,846 shares, no par.

Examples: Early in 1933 the United States Industrial Alcohol
Company and the Safety Car Heating and Lighting Company
announced plans under which the property account was written
down to a net value of $1, by means of a corresponding reduction
in stated capital and surplus. The transactions may be sum¬
marized in the condensed balance sheets shown in the table on
this page.

490

SECURITY ANALYSIS

The United States Industrial Alcohol revision was accompanied
by a statement to the effect that by reducing the book value of
fixed assets to $1 the necessity for future charges for depreciation
would be eliminated. It was proposed, however, to set up a
Reserve for Replacements account, by charges against income
of amounts deemed sufficient to provide for the replacement of
productive facilities. It was believed that for 1933 an adequate
amount of such charge would be $300,000, which might be com¬
pared with approximately $900,000 charged against income for
depreciation in 1932.

The Safety Car announcement carried the idea even further.
No provision for depreciation was made in 1932, so that a net
profit was reported for that year against a loss for 1931, although
income before depreciation was smaller in 1932. It was stated
in the annual report of the company for 1932 that: “By the
elimination of Depreciation on Fixed Assets as of December 31,
1932, all profits above Operating Expense, and Depreciation on
subsequently acquired Capital Assets, could be considered by
your Directors for distribution to the stockholders without any
decrease in the Company’s current assets.”

Earnings Manufactured from, Depreciation Account .—The
procedure followed by Safety Car is identical with that of our
imaginary Trucking Company C, which wrote down its truck to
$1 and thereby avoided charging depreciation to earnings. We
have already pointed out that if depreciation must be allowed
for in fact, it cannot be eliminated by bookkeeping entries. The
Safety Car stockholder does not earn a dollar more on his invest¬
ment because his fixed assets have been written down to nothing.
Nor can necessary expenditures for plant upkeep or replacement
be in any wise reduced by making believe that there no longer
is any plant. Let us examine the Safety Car Heating and Light¬
ing exhibit in somewhat the same manner as that of Eureka Pipe
Line. Over a ten-year period the expended depreciation charge
averaged about $500,000 per annum. The earnings record for
the decade is approximately as shown in the table on p. 491.

If this company were analyzed amid the uncertainties of 1933,
it would be impossible to determine whether the long-term or the
recent figures are a better guide to the future. But whatever
assumption is made on this score, it is quite clear that a depre¬
ciation charge must be allowed for. If no better than the 1932

ANALYSIS OF THE INCOME ACCOUNT

491

results can be expected, then a very small earning power at best
would be indicated, since actual expenditures on plant will no
doubt come close to, if they do not exceed, the reported “earn¬
ings” of $233,000. If by any chanqe the profits should return to
their ten-year average, the complete elimination of the former
depreciation charge would result in a serious overstatement of
the true earning power.

Item

Annual

average

1922-1931

Year

1931

Year

1932

Earnings before depreciation.

Depreciation charged.

Earnings as reported.

$1,721,000
6G9,000
1,052,000

$336,000
442,000
106,000(d)

$233,000

none

233,000

u Depreciation expended” (approximate)
Cash earnings available for the stock ...

$ 500,000

1,221,000

$130,000

206,000

$190,000

43,000

Sequel , 1933-1938.—During this period the company reported
average earnings of $590,000, or $6 per share, after charging
average depreciation of only $18,000. Had the 1922-1931 basis
of depreciation been maintained, there would have been no
earnings per share for the six-year period and a substantial profit
only in the year 1937. In that year the earnings as reported
reached $19.72 per share, and the price rose to 141, only to fall
as low as 48 in 1938. The advance in 1937 might be ascribed
to a twofold miscalculation of the market by (1) considering the
large volume of air-conditioning installation done in that year as if
it were fully recurring and (2) ignoring the necessity for a depre¬
ciation charge substantially higher than the company's meaning¬
less figure, if such a volume were to continue.

The United States Industrial Alcohol Company write-off did
not result in the complete elimination of depreciation charges
against earnings, but in lieu thereof it was proposed to set up a
“replacement reserve” to be determined arbitrarily by the
directors. For 1933 the amount was fixed at $300,000. A study
of the approximate figures for the preceding five years would
warrant grave doubts as to the adequacy of such a charge for
replacements under normal conditions.

492

SECURITY ANALYSIS

Item

Average
1928-1932
as reported *

Average 1928-1932,
based on proposed 1933
replacement reserve

Net before depreciation

$2,090,000

Depreciation charged...

1,350,000

300,000

Balance for common.. .

740,000

1,790,000

Earned per share.

* After deducting from earnings certain items charged by the company to surplus.

In this case the Net Plant account (Gross Plant less Deprecia¬
tion) increased $500,000 during the five-year period ( i.e ., from
$18,800,000 at the end of 1927 to $19,300,000 at the end of 1932).
In other words the money spent for property extensions and
replacements somewhat exceeded the total depreciation allowance
of $6,750,000. This development is characteristic of most of our
large corporations, which tend to add to their facilities as the
years pass. In all such rases it must be assumed that the depre¬
ciation charges based upon accepted accounting rules are the
minimum necessary for properly reflecting the conditions of the
business. They cannot soundly be reduced either by the corpor¬
ation through arbitrary write-downs or by the investor in his
individual calculations. Hence if the United States Industrial
Alcohol Company should regain its former profit-making ability,
a drastic reduction of the former depreciation reserves would in
all probability result in a misleading overstatement of the true
earning power. 1

Other Examples of Elimination of Fixed Assets: Commercial
Solvents Company wrote down its plant account to $1 in 1932.
May Department Stores and Kaufmann Department Stores both
wrote down thei" furniture and fixtures account to $1 in 1933 and
1929, respectively. Park and Tilford Company wrote down its
machinery and fixtures account to $1 in 1927. In all these cases
subsequent depreciation charges were reduced to less than a
suitable figure.

Stock Watering Reversed.—The new policy of writing off
fixed assets bears an interesting relationship to the recent concep¬
tions of stock values. It is a direct outgrowth of the ignoring
of asset values and the monopolizing of attention by the reported

1 For later data regarding United States Industrial Alcohol see material
on pp. 619-620.

ANALYSIS OF THE INCOME ACCOUNT

493

per-share earnings. A generation ago, when investors consulted
balance sheets to ascertain the net worth behind their shares,
this net worth was artificially inflated by writing up the book
value of the fixed assets far above .their actual cost. This in
turn permitted a corresponding overstatement of the capitaliza¬
tion at par. “ Stock watering,” as this practice was called,
constituted at that time one of the most severely criticized abuses
of Wall Street.

It is a striking commentary on the change in our financial
viewpoint that the term “stock watering” has practically disap¬
peared from the investor's vocabulary. By a strange paradox
the same misleading results that were obtained prior to 1914
by overstating property values are now sought by the opposite
stratagem of understating these assets. Erase the plant account ;
thereby eliminate the depreciation charge; thereby increase the
reported earnings; thereby enhance the value of the stock. The
idea that such sleight-of-hand could actually add to the value
of a security is nothing short of preposterous. Yet Wall Street
solemnly accepts this topsy-turvy reasoning, and corporate
managements are naturally not disinclined to improve their
showing by so simple a maneuver.

Purchaser’s Amortization of Ore Reserves.—The distinction
between the company's and the investor's allowance for amortiza¬
tion appears most clearly in cases involving depletion of
ore reserve's. As pointed out in Chap. 34 the amounts
charged off by a mining company for depiction are based upon
certain technical considerations which are likely to be quite
irrelevant to the stockholders' situation.

Example: In the table on p. 494 a study of the showing of
Homestake Mining Company for the year 1925 and again for 1938
will illustrate this point.

Superficially the price of 63 early in 1939 would seem to be
somewhat better justified by the past year's earnings than the
price of 50 in early 1926. But the reported earnings were based
upon the company's charges for depreciation and depletion, which
bear no relation to the price which the purchaser of the shares
is actually paying for the mine. It will again be helpful to view
the picture from the standpoint of a business man considering
the purchase of the entire enterprise at the valuations indicated
by the market price of the stock.

494

SECURITY ANALYSIS

In 1926 the valuation would be $12,500,000. For this sum
he would obtain about $2,500,000 in current assets (equivalent to
cash), so that the mine and plant would cost him only $10,000,000.
It is this capital investment which he would have to amortize,
i.e. recover out of earnings, together with a suitable profit
before the mine is exhausted. In 1926 the developed ore reserves
indicated a minimum life of 11 years for the property at the
current rate of production. Since new ore had continuously
been developed in amounts very nearly equal to the tonnage
mined, there was good reason to expect a life considerably longer

Homestake Mining Company

Item

1938

1925

Amount

Per

Amount

Per

Gross earnings.

$ 19,496,000

$97.0

$ 6,080,000

$24.32

Net earnings before depreciation

and depiction.

10,605,000

53.0

1,894,000

7.58

Depreciation and depletion.

3,664,000

18.3

1,330,000

5.32

Balance for dividends.

6,941,000

34.7

564,000

2.25

Market price (in March of follow¬

ing year).

Market value of enterprise*. . .

$126,000,000

$12,500,000

% earned on market value.

5.5%

4 5%

* 250,000 shares in 1025; 2,000,000 shares in 1938.

than the minimum figure. It would not be conservative, how¬
ever, to count on more than 20 years. In a mining venture of this
type the same amortization rate should ordinarily be applied
to the machinciy and other equipment as to the mine proper, on
the theory that the plant will last as long as the mine and will
then have to be scrapped.

The Purchaser’s Amortization Calculation. —The purchaser’s
amortization rate would therefore have to be somewhere hetween
5 and 9% annually on his $10,000,000 cost price for the mine.
How this would work out is shown in the table on p. 495, which
includes a corresponding analysis of the March 1939 situation.
The same maximum and minimum figures for expected life are
used in both cases because the reported ore reserves continued
to show a life of at least 11 years.

ANALYSIS OF THE INCOME ACCOUNT

495

Homestake Mining Company
Buyer's Amortization Calculation

Item

1925 earn¬
ings basis,
price 50

1938 earn¬
ings basis,
price 63

Paid for entire company.

$12,500,000

$126,000,000

Less net cash assets included.

2,500,000

13,200,000

Paid for mining property.

$10,000,000

$112,800,000

(Value of mining property on balance sheet). .

'20,960,000) |

(7,900,000)

Earnings before amortization.

1,900,000 1

10,600,000

Earnings required on cash assets.

(5%) 125,000

(3 %)400,000

Balance earned on mining investment.

$ 1,775,000

$10,200,000

% earned before amortization.

17.8%

9.0%

(Company’s amortization charge).

Investor’s amortization:

($1,330,000)

($3,664,000)

Maximum 9%.

900,000

10,200,000

Minimum 5%.

Earned on mining investment after amortiza¬
tion:

500,000

5,670,000

Minimum earnings .

875,000

Nil

Maximum earnings.

% earned on mining investment

1,275,000

4,530,000

Minimum.

8.8%

Nil

Maximum.

12.8%

From the business standpoint, the showing for 1925 (assuming
it could be expected to continue) would indicate a satisfactory
return on the investment at $50 per share. This is by no means
true, so far as the available facts are concerned, when dealing
with the 1938 earnings and the related price of about 63. The
company’s amortization charges for 1925 were considerably higher
than required by a purchase of the shares at 50; but on the other
hand the buyer at 63 could not be at all sure that the company’s
charges for 1938, even though increased over 1925, would be
adequate to amortize his investment. 1

In the more frequent case where a mining company’s charge
for depletion is not shown in its report, the same general approach
1 In the 1934 edition we used here the 1933 earnings of Homestake and its
price of 360 in March 1934 (equivalent to 45 after the 8-for-l split-up in
1937). The rise of Homcstakc’s price between 1934 and 1939 was somewhat
less than that of industrial companies generally.

496

SECURITY ANALYSIS

must be used in attempting an analysis. This means that
where the life of a property is limited, the stated depreciation
charge should also be ignored and the “ investor’s amortization ”
charged against the earnings before depreciation. The three
factors to be considered are (1) the price paid for the mining
property (total price less cash assets), (2) the earnings before
depreciation and depletion, and (3) the minimum life of the mine,
and, alternatively, its probable life.

Purchaser’s Amortization of Oil Reserves.—The application
of this principle to the oil industry is shown most readily by
selecting a company such as Texas Gulf Producing Company,
which is solely a producing enterprise and has clearly stated
the oil reserves on which the purchase of the stock must be based.
It is true, of course, that the company’s undeveloped leases
may turn out to possess important additional quantities of oil,
but that would be true of any large leascholdings and cannot give
them for the present any more than the nominal value represented
by the cost of acquisition.

Example: Texas Gulf Producing Company in 1937.

1. The Situation. —The significant facts relative to this com¬
pany^ amortization charges arc relatively simple. The com¬
pany is a producing enterprise solely. Most of its oil comes from
a single field in Texas. Its depreciation and depletion charge per
barrel is found by dividing the estimated remaining oil reserves
into the net value of the properties on the books.

In 1937 the oil reserves averaged about 26 million barrels, and
the net property account about $9.5 millions, resulting in an
amortization charge of 36.05 cents per barrel, or $689,000 for the
year’s production. Of this amount, however, only $397,000 was
charged to earnings, the remainder being deducted from “ surplus
arising from appraisal” on the balance sheet.

Earnings per share equaled $1.13 per share before amortization,
68 cents per share as reported (on the basis of amortization
charged to earnings) and only 35 cents per share after full amorti¬
zation including the portion charged to surplus.

Book value of the stock was about $10 per share. The market
price in 1937 ranged between 9% and 2.

2. The Investor’s Calculation .—Omitting the possibility of new
discoveries or developments—a nonmeasurablc, speculative
factor—the purchaser of these shares would count on about
13 years of life remaining in the properties and would therefore

ANALYSIS OF THE INCOME ACCOUNT

497

deduct about 8% of his purchase price for annual amortization.
Hence at the high price of in 1937, his amortization would
about equal the company’s total charge, and thus the remaining
earnings would amount to only 4% on the price paid. At the
year’s average price of about 5 % his allowance would approxi¬
mate the company’s charge to earnings; and at the low price of
2 it would need only 16 cents and hence have left an indicated
annual profit of 97 cents, or about 50% on the price paid.

Purchaser’s Amortization of Patents. —A large number of
important manufacturing companies own patents that are
carried on their books at $1 or else at their cost—which is gener¬
ally a relatively small amount. It is standard accounting prac¬
tice to write off such cost by equal annual charges to earnings
during the life of the patent, which is 17 years from the date it is
granted. But the investor’s viewpoint requires an entirely
different approach. The question for him is how much is he
paying for the patent when he buys the stock at a given price—
and it is this amount that he must write off against the subsequent
earnings.

General Rule: A little thought will show that in the typical case
no such calculation is practicable. The investor cannot tell
what part of the price of the stock represents the current valua¬
tion of the patents, for he is in no position to gage accurately
the effect of the expiration of the company’s patents upon its
earnings. If we take concerns like General Electric or Radio
Corporation of America, we know that their patents bulk largo
in the picture; but only the most exhaustive investigation could
give us any idea at all as to how to allocate the current market
value of the enterprise as between the innumerable patents and
the other very real assets. Even when the situation appears
much simpler, because a single important patent is at stake, it is
easy to miscalculate its true importance to the enterprise.

Examples: In the case of Gillette Safety Razor Company the
expiration of the basic patents was followed unexpectedly by a
number of years of largely increased earnings and by an enormous
advance in the market value of the shares. The opposite
development occurred in the case of American Arch Company,
which supplied patented arch brick for locomotives to nearly
all the railroads of the United States. Because of the technical
nature of its business and its strong trade position, those identified
with this company were confident that it would hold its customers

498

SECURITY ANALYSIS

after its patents expired in 1926. But immediately thereafter
competition compelled a drastic cut in prices, the earnings
dwindled, and the price of the stock collapsed.

Our conclusion from all the foregoing must be that patents
should not be valued as a quantitative factor , when the investor
is dealing with the ordinary manufacturing business. Patent
ownership must be considered as part of the company’s trade
position, reflecting itself in one’s general view of the future of the
enterprise. It follows that the $1 valuation of patents is the
soundest for the investor’s purpose; that amortization of patents
can be added back to earnings if the amount is substantial 1 ;
and hence, if such amortization is charged to surplus instead of
income, 2 it is not necessary to correct the earnings figure.

Special Cases .—When a company’s business consists primarily
in collecting royalties on a patent or group of patents, it is
possible to make a more definite provision for amortizing the
investment therein. It should be obvious that such provision
mr t be related to the price paid by the investor for his interest
in the patent, rather than to the company’s book cost of the
patent on which its own amortization charge is based. The
following three examples illustrate this point; but they also
emphasize a more significant factor which is present in all analyses
applied to common stocks, viz that calculations based on the
present and the past can readily be upset by the unpredictable
events of the future.

Example A: Centrifugal Pipe Corporation in 1929
(Conclusion Vindicated)

1. The Situation .—This company controlled American and
foreign patents on the De Lavaud process for making metal pipe.

1 Example: Prior to 1933 United States Huffman Machinery Company
charged earnings with over $200,000 per annum, or about $1 per share of
common, for amortization of patents. The analyst should have increased
the reported earnings by this amount and then subjected them to careful
scrutiny because of the patent situation and other matters ( e.g . large receiv¬
ables) affecting the future of the business. In 1933 the company retraced
its steps by writing the patents down to $1, reducing the stated capital and
restoring to earned surplus about $1,500,000 previously charged off for
amortization of patents.

1 Example: American Laundry Machinery Company regularly charges a
small amount against surplus to write down its patent account.

ANALYSIS OF THE INCOME ACCOUNT

499

Exclusive license to manufacture pipe under this process was
given, on a royalty basis, to United States Cast Iron Pipe Com¬
pany. The agreement extended to 1938, although the basic
patents apparently expired in 1934. Various foreign licenses
were also granted, expiring in 1934-1936.

In 1929 the price of the stock varied between 434 and 13 .
Earnings both for 1928 and for 1924-1928 had been $1.05 per
share on 432,000 shares, before allowing for amortization of
patents, which the company was taking at the annual rate of
$1.72 per share. (This was derived from an initial valuation
of $7,000,000 given the chief patents at the end of 1923, at which
time they had 11 years to run.) On this basis the company
showed a loss after amortization.

2. The Investor's Calculation .—An analysis made in 1929
might have suggested earnings of about $1 per share for the ten
years ending with 1938, following which no additional profits
could be counted on with assurance. The investor’s annual
amortization charges would thus vary between 43 cents and $1.30,
corresponding to a purchase price between 434 an d 13.
Obviously, at $13 per share there could be no earnings on the
investment unless profits were greater than in the past. At $5
per share, on the other hand, the $1 estimate would yield an
annual profit of 10% after allowance of 50 cents for amortization.

3. The Sequel .—Strangely enough, the results indicated at the
beginning of 1929 were exactly realized in the following ten years.
In this period the company earned $10 per share, of which it paid
$6 in dividends. In 1939 it practically wound up its affairs by
distributing $3.80 in cash plus a residual stock worth about
50 cents per share.

Example B: IIazeltine Corporation in 1937 (Calculation
Affected by New Developments)

1. The Situation .—This company was organized in 1924
and controlled the Neutrodync patents for radio receivers,
which apparently expired in 1936. Other patents were also
acquired.

In the ensuing thirteen years its results fluctuated widely,
but it earned an average of about $2.40 per share, from which it
reserved $1.50 per annum to amortize its patent account. Divi¬
dends were paid irregularly, averaging $1.70 per annum, mainly

800

SECURITY ANALYSIS

out of the reserve for amortization of patents. In 1936 alone
earnings before amortization were $3.70 per share. In 1937
the stock sold as low as $7 (which was about equal to the accumu¬
lated cash assets) and as high as 18%.

2. The Investor's Calculation .—If the investor assumed that
the company’s chief revenue was derived from its Neutrodyne
patents, he would have concluded that the stock was too high at
18%, since expiration of those patents in the near future would
apparently severely reduce the future earning power. At 7,
on the other hand, the stock could still appear cheap, in view of
the substantial cash assets and the prospects of some earnings
from the remaining patents. Actually this would have been a
superficial analysis, since the record showed that the company
controlled hundreds of patents of various sorts. Hence nothing
short of a careful inquiry into the details of Hazel tine’s business
would have warranted a conclusion as to the relative value of the
expiring and continuing patents.

3. The Sequel .—The company’s earnings proved to be fully as
high in 1937-1938 as they had been in 1936. A new patent
covering a coupling system used in most receiving sets was issued
to it in 1938 and gave it as strong a position in the field as it had
formerly held. The price of the stock advanced to 30 in 1938
and to 36 in 1939.

Example C: International Cigar Machinery Company
in 1939 (A Current Analysis)

1. The Situation .—This company’s chief patents give it
control over the manufacture of cigars by machine. It also
owns other patents of less importance in the field. The original
cigar-machinery patents have apparently expired, but new
improvements have maintained the company’s position.

Earnings have come mainly from royalties and sales of licenses.
In the 10 years 1929-1938 they varied between $2.08 and $3.33
per share and amounted to $2.28 in 1938, on 600,000 shares.
These figures are after relatively small “depreciation and
amortization charges” of about 30 cents per share annually.
The company’s balance sheet at the end of 1938 lumped all
intangibles together at $14,000,000 gross, of which amortizable
patents must have represented a relatively small amount, and
nonamortizable good-will the major portion. Net working

ANALYSIS OF THE INCOME ACCOUNT

601

capital and other tangible assets amounted to only $2 per share.
In 1939 the price of the stock ranged between 20 and 24.

2. The Investor's Calculation .—If the company’s business
were thought to be largely dependent on any single set of patents,
an average price of 22 could not be justified. For in that case it
would be unlikely that future earnings up to the expiry of the
patents would be sufficient to pay back the investment in full plus
suitable earnings thereon. In other words, any conservative
amortization charge would condemn the purchase if based on the
current patent situation alone.

On the other hand, the market price may be justified if in the
future the company can maintain its patent and license control
of the industry by means of improvements in the art. This it
has been able to do in the past. It may be benefited also by an
increased use of machinery as against hand manufacture, due to
constantly lower selling prices for cigars. Obviously, therefore,
the evaluation of this issue is essentially a matter for industry
analysis and forecasting, and not for the application of invest¬
ment-accounting technique to a definite state of facts.

Rules Summarized.—Our lengthy discussion of amortization
policies may be summarized in the following rules:

Rule 1: The company’s amortization charges are to bo accepted in analysis
whenever (both):

a. They are based on regular accounting rules applied to fair valuations
of the fixed assets, and

b. The net plant account has not decreased over a period of years.

Rule 2: The company’s charges may be reduced in the analyst’s calcula¬
tions if they regularly exceed the cash expenditures on the property. In
such a case the average cash expenditures may be deducted from earnings
as a provisional depreciation charge and the balance of depreciation included
as part of the obsolescence hazard , which tends to reduce the valuation of the
average cash earning power. The obsolescence allowance will be based
upon the 'price paid for the enterprise by the investor and not upon either the
book value or the reproduction cost of the fixed assets.

Rule 3: The company’s charges must be increased in the analyst’s calcula¬
tions if they are both less than the average cash expenditures on the property
and less than the reserve required by ordinary accounting rules applied to
the fair value of the fixed assets used in the business.

Contingency and Similar Reserves. —Conservatively managed
companies in former days were wont to charge certain arbitrary
amounts against the earnings of good years to absorb any special

502

SECURITY ANALYSIS

losses that might later arise, usually in a bad year. The intent
of this policy was to equalize the earnings in prosperity and
depression. In this respect it resembled the use of accumulated
earnings of subsidiary companies discussed in Chap. XXXIII.
Experience has shown that such devices for artificially modifying
the actual earnings are too readily open to abuse. Intelligent
financial opinion—as represented by the New York Stock
Exchange—insists, therefore, that the management disclose the
true results of each year and leave all equalization and averaging
to be done by the stockholders.

Examples: The annual report of the Coca-Cola Company for
1928 stated that “The Company’s position has been greatly
strengthened during the last five years by setting aside a reserve
for contingencies of approximately $5,000,000.00.” Reports
for the preceding five years showed that the reserve had been
accumulated by charges against income in varying amounts and
for a miscellany of purposes. In the years 1929-1939 the policy
was continued except in 1933 and 1934, with the result that
the “Reserve for contingencies and miscellaneous operations”
set up by charges against income amounted to $13,011,479 at the
end of 1939.

In 1939 Continental Steel Company deducted $300,000 as a
reserve for contingencies from its reported earnings for the second
half-year, reducing the earnings per share from $4.62 to $3.13.

American Commercial Alcohol Company

Item

Total

Per share

1931 net loss.

$597 } 000
586,000

$5 18(d)*
3.01

1932 net profit.

Two years' net loss.

$ 11,000

0.17(d)

* Adjusted to $20 par-value basis.

Use of Contingency and Similar Reserves to Distort the Earnings
Picture .—During the years 1931 and 1932, however, contingency
and similar reserves were resorted to by many companies with
the effect of greatly obscuring and confusing their annual state¬
ments. These reserves were created for a threefold purpose:
(1) to permit losses to be charged against surplus instead of
against income, (2) to gloss over the actual taking of the loss, and
(3) in some cases to lay the groundwork for inflated earnings in

ANALYSIS OF THE INCOME ACCOUNT

503

subsequent years. A detailed analysis of the reports of American
Commercial Alcohol Corporation for 1931 and 1932 may serve
to make these points clearer to the reader.

The results for the two years as given by the company in its
annual statements were as shown in the table on p. 502.

From these figures it would appear that the company had about
broken even during the two depression years taken together and
that it had realized substantial earnings during 1932. But the
balance sheets covering this period, which arc presented in con¬
densed form below, point to an entirely different conclusion.
(Note that no dividends were paid during this time.)

Condensed Balance Sheets of American Commercial Alcohol
Corporation, 1930-1932
(Unit $1,000)

Item

Dec. 31, 1930

Dec. 31, 1931

Dec. 31, 1932

Current assets.

$2,057

$2,329

$2,588

Less current liabilities_

294

1,225

1,327

Net working capital.

Fixed and miscellaneous assets

$2,303

$1,104

$1,261

less depreciation.

0,440

6,120

0,220

Total net resources. ..

$8,803

$7,230

$7,481

Capital.

$3,775*

$3,764

$3,895

Miscellaneous reserves.

250

416

413

Surplus.

4,772

3,050

3,173

Total.

$8,803

$7,230

$7,481

* Adjusted to $20 par value (report showed capital of $8,000,098 and surplus of $46,484).

These balance sheets show that instead of a merely nominal
loss of $11,000 for the two years together, there was an actual
shrinkage of $1,600,000 in the company’s surplus, the greater
part of which was represented by an increase in current debt.

The extraordinary discrepancy between these two exhibits was
brought about by the exclusion from ’the income account of
numerous losses and deductions, which were charged against
surplus instead. This simple device was made more complicated
—and therefore not so readily intelligible to stockholders—by
the use of three stages of accounting procedure, viz.:

504

SECURITY ANALYSIS

1. The transfer of a large amount from Capital to Capital Surplus.

2. The transfer of various sums from Capital Surplus to Reserves.

3. The charging of various losses against these Reserves, and of other
losses directly against Surplus.

At the end of 1931 American Commercial Alcohol transferred
the sum of $4,875,000 from Capital to Capital Surplus. It
then used $576,000 of this Capital Surplus to cancel the accumu¬
lated profit-and-loss deficit. The entries in the surplus account
for 1931 and 1932 show the following remarkable assortment of
extraordinary losses and adjustments.

Reduction of inventory value under previous

year's contracts. $ 145,000

Losses due to trading in corn options. 88,000

Reduction in the value of fixed assets. 157,000

Losses due to revaluation of containers. 213,000

Balance of organization expenses. 73,000

Income tax for prior years... 54,000

Excess cost of raw materials 1932. 255,000

Payment under salary contract. 40,000

Loss on sale of treasury stock, etc. 46,000

Miscellaneous items (10 debits and 1 credit). 117,000

Reserve for contingencies. 400,000

Charges to surplus, 1931-1932. $1,588,000

Loss for two years, per income account. 11,000

Total reduction in surplus, 1931-1932. $1,599,000

It is evident that a substantial part of these charges against
Surplus actually represented operating losses, which were
responsible in turn for the large increase in current liabilities.
It should be noted furthermore that the company carried forward
into 1933 a new contingency reserve of $400,000, against which
might be charged future losses that properly should reflect
themselves in the income account.

Hence the accounting procedure of this company—as well as
of many others—in 1931 and 1932 not only concealed the true
extent of the losses suffered but also was calculated to understate
the losses or to overstate the profits of succeeding years. 1

A particular and frequent type of contingency reserve is a
reserve for future inventory decline. In our discussion of various

1 A Senate Investigating Committee (on Banking and Currency, inves¬
tigating “Stock Exchange Practices") in February 1934 elicited the fact
that there had been continuous pool activities in American Commercial
Alcohol stock between February 1932 and July 1933.

ANALYSIS OF TIIE INCOME ACCOUNT

506

permissible methods of figuring inventory (in Chap. XXXII) we
pointed out that the Normal Stock Method aims to mark down
the basic stock to so low a figure that no drop in price will require
a further charge against earnings. This method involves, in
essence, the use of a contingency reserve for future inventory
decline, calculated in accordance with a definite and continuing
policy. On the whole we must regard a device of this kind as
meriting praise rather than criticism. But it is essential that
the analyst allow for the use of such reserves when studying a
single year’s results and particularly when comparing several
companies in the same field. Let us further remind the reader
that the setting up of an inventory reserve out of surplus, what¬
ever the theory behind it, almost invariably results in overstating
the reported profits over a period of years.

CHAPTER XXXVII

SIGNIFICANCE OF THE EARNINGS RECORD

In the last six chapters our attention was devoted to a critical
examination of the income account for the purpose of arriving
at a fair and informing statement of the results for the period
covered. The second main question confronting the analyst
is concerned with the utility of this past record as an indicator
of future earnings. This is at once the most important and the
least satisfactory aspect of security analysis. It is the most
important because the sole practical value of our laborious study
of the past lies in the clue it may offer to the future; it is the least
satisfactory because this clue is never thoroughly reliable and it
frequently turns out to be quite valueless. These shortcomings
detract seriously from the value of the analyst's work, but they
do not destroy it. The past exhibit remains a sufficiently
dependable guide, in a sufficient proportion of cases, to warrant
its continued use as the chief point of departure in the valuation
and selection of securities.

The Concept of Earning Power. —The concept of earning power
has a definite and important place in investment theory. It
combines a statement of actual earnings, shown over a period of
years, with a reasonable expectation that these will be approxi¬
mated in the future, unless extraordinary conditions supervene.
The record must cover a number of years, first because a con¬
tinued or repeated performance is always more impressive than a
single occurrence and secondly because the average of a fairly
long period will tend to absorb and equalize the distorting
influences of the business cycle.

A distinction must be drawn, however, between an average
that is the mere arithmetical resultant of an assortment of dis¬
connected figures and an average that is “normal” or “modal,”
in the sense that the annual results show a definite tendency to
approximate the average. The contrast between one type of

506

ANALYSIS OF THE INCOME ACCOUNT

507

earning power and the other may be clearer from the following
examples:

Adjusted Earninos per Share 1923-1932

Year

S. H. Kress

Hudson Motors

1932

$2.80

$ 3.64(d)

1931

4.10

1 25(d)

1930

4 49

0.20

1929

5.92

7 26

1928

5 76

8.43

1927

5 26

9 04

1926

4 G5

3 37

1925

4.12

13 39

1924

3.06

5.09

1923

3.39

5 56

10-year average.

54 36

S 4 75

The average earnings of about $4.50 per share shown by
S. H. Kress Company can truly be called its “ indicated earning
power,” for the reason that the figures of each separate year
show only moderate variations from this norm. On the other
hand the Hudson Motors average of $4.75 per share is merely
an abstraction from ten widely varying figures, and there was no
convincing reason to believe that the earnings from 1933 onward
would bear a recognizable relationship to this average. A
similar conclusion was drawn from our discussion of the exhibit
of J. I. Case Company on page 122.

These conclusions, reached in 1933, are supported by the results
of the six years following:

Earnings per Share

Year

S. II. Kress 1

Hudson Motors

J. I. Case

1933

$4 23

$3 87(d)

$14 06(d)

1934

4 76

2 10(d)

7.38(d)

1935

4 63

0 38

5 70

1936

4.62

2 14

12.37

1937

4 62

0.42

19 20

1938

2.76

2.94(d)

8.89

1939

3 86

. 86 (d)

1.87(d)

1 Stated on basis of old capitalisation, beforo 2-for-l split-up in 1936.

S08

SECURITY ANALYSIS

Quantitative Analysis Should Be Supplemented by Qualitative
Considerations. —In studying earnings records an important
principle of security analysis must be borne in mind:

Quantitative data are useful only to the extent that they are sup¬
ported by a qualitative survey of the enter prise.

In order for a company’s business to be regarded as reasonably
stable, it does not suffice that the past record should show stabil¬
ity. The nature of the undertaking, considered apart from any
figures, must be such as to indicate an inherent permanence of
earning power. The importance of this additional criterion was
well illustrated by the case of the Studebaker Corporation which
was used as an example in our discussion of qualitative factors
in analysis on page 508. It is possible, on the other hand, that
there may be considerable variation in yearly earnings, but there
is a reasonable basis nevertheless for taking the average as a
rough index at least of future performance. In 1034 we cited
United States Steel Corporation as a leading case in point. The
text of our discussion was as follows:

The annual earnings for 1923-1932 are given below.

United States Steel Corporation, 1923-1932

Year

Earnings
per share
of common*

Output of
finished
steel, tons

% of total

1 output of
country

Net per ton
before
deprec.

1932

$11.08(d)

3,591 000

34.4

S 3 64(d)

1931

1 . 40 (d)

7,196,000

37 5

5.71

1930

9.12

11,609,000

39.3

13.10

1929

21 19

15,303,000

37.3

16 90

1928

12.50

13.972,000

37.1

13 83

1927

8.81

12,979,000

39.5

12 66

1926

12 85

14,334,000

40.4 j

13 89

1925

9.19

13,271,000

39.7

12 49

1924

8.41

11,723,000

41.7 !

13.05

1923

11.73

14,721,000

44.2 1

12.20

10-year average.

$ 8.13

11,870,000

39.1

11.03

* Adjusted for changes in capitalization.

If compared with those of Studebaker for 1920-1929, the foregoing
earnings show much greater instability. Yet the average of about
$8 per share for the ten-year period has far more significance as a guide

ANALYSIS OF THE INCOME ACCOUNT

509

to the future than had Studebaker's indicated earning power of about
$6.75 per share. This greater dependability arises from the entrenched
position of United States Steel in its industry; and also from the rela¬
tively narrow fluctuations in both the annual output and the profit
per ton over most of this period. These two elements may be used as a
basis for calculating approximate “ normal earnings” of U. S. Steel,
somewhat as follows:

Normal or usual annual production of

finished goods.

Gross receipts per ton of finished products
Net earnings per ton before depreciation..
Net earnings on 13,000,000 tons. . . .
Depreciation, bond interest, and preferred

dividends.

Balance for 8,700,000 shares of common.
Normal earnings per share.

13,000,000 tons
$100 00
$12.50

$160,000,000 00

90,000,000 00
70,000,000 00
$8.00

The average earnings for the 1923-1932 decade are thus seen to
approximate a theoretical figure based upon a fairly well-defined
“ normal” output and profit margin. (The increase in number of shares
outstanding prevents this normal figure from exceeding the ten-year
average.) Although a substantial margin of error must be allowed for
in such a computation, it at least supplies a starting point for an intelli¬
gent estimate of future probabilities.

Examining this analysis six years later, we may draw some con¬
flicting conclusions as to its value. United States Steel's earnings
did recover to $7.88 per share in 1937 ($8.31 before the surtax on
undistributed profits). The price advanced from the 1933 aver¬
age of 45)^ to a high of 126 in March 1937. Hence our implica¬
tion that the company had a better earning power than the 1932
results and stock prices reflected would seem to have been amply
justified by the event.

But actually the average earnings for 1934-1939 have been
quite disappointing (amounting to no more than 14 cents per
share). If these results have as much validity for the steel indus¬
try as they have for most lines of business, we should have to
admit that the analysis based on 1923-1932 was not really useful,
because the underlying conditions in steel have changed for the
worse. (The change consists chiefly in much higher unit costs
and a lower average output, selling prices on the whole having
been well maintained. 1 )

1 It may be interesting to note that our 1933 conclusions as to the earning
power of United States Steel are quite similar to those reached by J. B.

510

SECURITY ANALYSIS

Current Earnings Should Not Be the Primary Basis of
Appraisal. —The market level of common stocks is governed
more by their current earnings than by their long-term average.
This fact accounts in good part for the wide fluctuations in
common-stock prices, which largely (though by no means inva¬
riably) parallel the changes in their earnings between good years
and bad. Obviously the stock market is quite irrational in thus
varying its valuation of a company proportionately with the
temporary changes in its reported profits. 1 A private business
might easily earn twice as much in a boom year as in poor times,
but its owner would never think of correspondingly marking
up or down the value of his capital investment.

This is one of the most important lines of cleavage between
Wall Street practice and the canons of ordinary business.
Because the speculative public is clearly wrong in its attitude on
this point, it would seem that its errors should afford profitable
opportunities to the more logically minded to buy common
stocks at the low prices occasioned by temporarily reduced
earnings and to sell them at inflated levels created by abnormal
prosperity.

The Classical Formula for 11 Beating the Stock Market ”—We
have here the long-accepted and classical formula for “ beating
the stock market.” Obviously it requires strength of character
in order to think and to act in opposite fashion from the crowd
and also patience to wait for opportunities that may be spaced
years apart. But there are still other considerations that
greatly complicate this apparently simple rule for successful
operations in stocks. In actual practice the selection of suitable

Williams in his elaborate study of this company contained in his book The
Theory of Investment Value f pp. 409-462. But note also, as against the
foregoing indication of normal earning power, the rather pessimistic impli¬
cations of the longer range study of United States Steel’s position on pp.
628-631 below. The company’s failure to reestablish this earning power in
1934-1939 might suggest that the latter analysis deserved the greater weight.

1 The rise of United States Steel to 126 in March 1937, already mentioned,
is a striking example of this folly of the stock market. It was based on a
single good year, following six bad or mediocre ones. Within twelve
months the price had declined to 42—a loss of two-thirds of its quotation,
and over $730,000,000 in aggregate market value for this single issue.
The range of Youngstown Sheet and Tube and Jones and Laughlin Steel
in that period was even wider.

ANALYSIS OF THE INCOME ACCOUNT

511

buying and selling levels becomes a difficult matter. Taking
the long market cycle of 1921-1933, an investor might well
have sold out at the end of 1925 and remained out of the market
in 1926-1930 and bought again in the depression year 1931.
The first of these moves would later have seemed a bad mistake
of judgment, and the last would have had most disturbing conse¬
quences. In other market cycles of lesser amplitude such
serious miscalculations are not so likely to occur, but there is
always a good deal of doubt with regard to the correct time for
applying the simple principle of “buy low and sell high.”

It is true also that underlying values may change substantially
from one market cycle to another, more so, of course, in the case
of individual issues than for the market as a whole. Hence if a
common stock is sold at what seems to be a generous price in
relation to the average of past earnings, it may later so improve
its position as to justify a still higher quotation even in the next
depression. The converse may occur in the purchase of securities
at subnormal prices. If such permanent changes did not fre¬
quently develop, it is doubtful if the market would respond
so vigorously to current variations in the business picture. The
mistake of the market lies in its assumption that in every case
changes of this sort are likely to go farther, or at least to persist,
whereas experience shows that such developments are exceptional
and that the 'probabilities favor a swing of the pendulum in the
opposite direction.

The analyst cannot follow the stock market in its indiscrim¬
inate tendency to value issues on the basis of current earnings.
He may on occasion attach predominant weight to the recent
figures rather than to the average, but only when persuasive
evidence is at hand pointing to the continuance of these current
results.

Average vs. Trend of Earnings. —In addition to emphasizing
strongly the current showing of a company, the stock market
attaches great weight to the indicated trend of earnings . In
Chap. XXVII we pointed out the twofold danger inhering in
this magnification of the trend—the first being that the supposed
trend might prove deceptive, and the second being that valu?~
tions based upon trend obey no arithmetical rules and therefore
may too easily be exaggerated. There is irdeed a fundamental
conflict between the concepts of the average and of the trend, as

512

SECURITY ANALYSIS

applied to an earnings record. This may be illustrated by the
following simplified example:

Company

Earned per share in successive years

7th

(cur¬

rent)

Average
of 7
years

Trend

1st

2nd

4th

5th

Gth

$ 1

$ 2

$ 3

$ 4

S 4

Excellent

Neutral

Bad

On the basis of these figures the better the trend, when com¬
pared with the same current earnings (in this case $7 per share),
the poorer the average and the higher the average the poorer
the trend. They suggest an important question respecting the
theoretical and practical interpretation of earnings records:
Is not the trend at least as significant for the future as the
average? Concretely, in judging the probable performance of
Companies A and C over the next five years, would not there
be more reason to think in terms of a sequence of $8, $9, $10, $11,
and $12 for A and a sequence of $7, $6, $5, $4, and $3 for C
rather than in terms of the past average of $4 for A and $10 for C?

The answer to this problem derives from common sense
rather than from formal or a priori logic. The favorable trend
of Company A’s results must certainly be taken into account,
but not by a mere automatic projection of the line of growth
into the distant future. On the contrary, it must be remembered
that the automatic or normal economic forces militate against
the indefinite continuance of a given trend. 1 Competition,
regulation, the law of diminishing returns, etc., are powerful
foes to unlimited expansion, and in smaller degree opposite
elements may operate to check a continued decline. Hence
instead of taking the maintenance of a favorable trend for
granted—as the stock market is wont to do—the analyst must
approach the matter with caution, seeking to determine the
causes of the superior showing and to weigh the specific elements
of strength in the company’s position against the general obstacles
in the way of continued growth.

Attitude of Analyst Where Trend Is Upward .—If such a quali¬
tative study leads to a favorable verdict—as frequently it should

1 See our discussion of the Schletter and Zander example in Chap. XXVII.

ANALYSIS OF THE INCOME ACCOUNT

513

—the analyst’s philosophy must still impel him to base his invest¬
ment valuation on an assumed earning power no larger than the
company has already achieved in a period of normal business.
This is suggested because, in our opinion, investment values can
be related only to demonstrated performance; so that neither
expected increases nor even past results under conditions of
abnormal business activity may be taken as a basis. As we shall
point out in the next chapter, this assumed earning power may
properly be capitalized more liberally when the prospects appear
excellent than in the ordinary case, but we shall also suggest that
the maximum multiplier be held to a conservative figure (say, 20,
under the conditions of 1940) if the valuation reached is to be
kept within strictly investment limits. On this basis, assuming
that general business conditions in the current year are not
unusually good, the earning power of Company A might be
taken at $7 per share, and its investment value might be set
as high as 140. 1 The divergence in method between the stock
market and the analyst—as we define his viewpoint—would
mean in general that the price levels ruling for the so-called
“good stocks” under normal market conditions are likely to
appear overgenerous to the conservative student. This does not
mean that the analyst is convinced that the market valuation is
wrong but rather that he is not convinced that its valuation is
right. He would call a substantial part of the price a “specula¬
tive component,” in the sense that it is paid not for demonstrated
but for expected results. (This subject is discussed further in
Chap. XXXIX.)

Attitude of Analyst Where Trend Is Downward. —Where the
trend has been definitely downward, as that of Company (7,
the analyst will assign great weight to this unfavorable factor.
He will not assume that the downcurve must presently turn
upward, nor can he accept the past average—which is much
higher than the current figure—as a normal index of future
earnings. But he will be equally chary about any hasty con¬
clusions to the effect that the company’s outlook is hopeless, that
its earnings are certain to disappear entirely and that the stock
is therefore without merit or value. Here again a qualitative

1 See Appendix Note 53, p. 780, for a reference to the more conservative
viewpoint on this matter expressed by us in the 1934 edition of this work
and the reasons for the change.

514

SECURITY ANALYSIS

study of the company's situation and prospects is essential to
forming an opinion whether at some price , relatively low, of course,
the issue may not be a bargain, despite its declining earnings
trend. Once more we identify the viewpoint of the analyst with
that of a sensible business man looking into the pros and cons
of some privately owned enterprise.

To illustrate this reasoning, we append the record of net earn¬
ings for 1925-1933 of Continental Baking Corporation and
American Laundry Machinery Company.

Year

Continental

Baking

American

Laundry

Machinery

1933

$2,788,000

Cl ,1S7,000(d)

1932

2,759,000

OSG,000(d)

1931

4,243,000

772,000

1930

6,114,000

1,849,000

1929

6,671,000

3,542,000

1928

5,273,000

4,128,000

1927

5,570,000

4,221,000

1926

6,547,000

4,807,000

1925

8,794,000

5,101,000

The profits of American Laundry Machinery reveal an uninter¬
rupted decline, and the trend shown by Continental Baking is
almost as bad. It will be noted that in 1929—the peak of pros¬
perity for most companies—the profits of those concerns were
substantially less than they were four years earlier.

Wall Street reasoning would be prone to conclude from this
exhibit that both enterprises are definitely on the downward path.
But such extreme pessimism would be far from logical. A study
of these two businesses from the qualitative standpoint would
indicate first that the respective industries are permanent and
reasonably stable and secondly that each company occupies a
leading position in its industry and is well fortified financially.
The inference would properly follow that the unfavorable ten¬
dency shown during 1925-1932 was probably due to accidental
or nonpermanent conditions and that in gaging the future
earning power more enlightenment will be derived from the sub¬
stantial average than from the seemingly disastrous trend. 1

1 The results since 1933 would tend to bear out this earlier conclusion, at
least in part.

ANALYSIS OF THE INCOME ACCOUNT

515

Deficits a Qualitative, Not a Quantitative Factor. —When a
company reports a deficit for the year, it is customary to calculate
the amount in dollars per share or in relation to interest require¬
ments. The statistical manuals will state, for example, that in
1932 United States Steel Corporation earned its bond-interest
“deficit 12.40 times” and that it showed a deficit of $11.08 per
share on its common stock. It should be recognized that such
figures, when taken by themselves, have no quantitative sig¬
nificance and that their value in forming an average may often be
open to serious question.

Let us assume that Company A lost $5 per share of common in
the last year and Company B lost $7 per share. Both issues
sell at 25. Is this an indication of any sort that Company A
stock is preferable to Company B stock? Obviously not; for
assuming it were so, it would mean that the more shares there
were outstanding the more valuable each share would be. If
Company B issues 2 shares for 1, the loss would be reduced to
$3.50 per share, and on the assumption just made, each new
share would then be worth more than an old one. The same
reasoning applies to bond interest. Suppose that Company A
and Company B each lost $1,000,000 in 1932. Company A has
$4,000,000 of 5% bonds and Company B has $10,000,000 of 5%
bonds. Company A would then show interest earned “deficit
5 times” and Company B would earn its interest “deficit 2
times.” These figures should not be construed as an indication
of any kind that Company yl’s bonds are less secure than Com¬
pany B’s bonds. For, if so, it would mean that the smaller the
bond issue the poorer its position—a manifest absurdity.

When an average is taken over a period that includes a number
of deficits, some question must arise as to whether or not the
resultant figure is really indicative of the earning power . For
the wide variation in the individual figures must detract from the
representative character of the average. This point is of con¬
siderable importance in view of the prevalence of deficits during
the depression of the 1930s. In the case of most companies
the average of the years since 1933 may now T be thought more
representative of indicated earning power than, say, a ten-year
average 1930-1939. 1

1 It is an open question whether or not either the ten-year period 1930-
1939 or the six years 1934-1939 fairly reflect the future earning power of

516

SECURITY ANALYSIS

Intuition Not a Part of the Analyst’s Stock in Trade.—In the

absence of indications to the contrary we accept the past record
as a basis for judging the future. But the analyst must be on
the lookout for any such indications to the contrary. Here we
must distinguish between vision or intuition on the one hand, and
ordinary sound reasoning on the other. The ability to see what
is coming is of inestimable value, but it cannot be expected to be
part of the analyst’s stock in trade. (If he had it, he could dis¬
pense with analysis.) He can be asked to show only that moderate
degree of foresight which springs from logic and from experi¬
ence intelligently pondered. It was not to be demanded of the
securities statistician, for example, that he foretell the enormous
increase in cigarette consumption since 1915 or the decline in the
cigar business or the astonishing stability of the snuff industry;
nor could he have predicted—to use another example—that the
two large can companies would be permitted to enjoy the full
benefits from the increasing demand for their product, without
the intrusion of that demoralizing competition which ruined the
profits of even faster growing industries, e.g. } radio.

Analysis of the Future Should Be Penetrating Rather than Pro¬
phetic. —Analytical reasoning with regard to the future is of a
somewhat different character, being penetrating rather than
prophetic. 1

Example: Let us take the situation presented by Intertype
Corporation in March-July 1939, when the stock was selling at $8
per share. This old, established company was one of the leaders
in a relatively small industry (line-casting machines, etc., for
the printing trade). Its recent earnings had not been favorable,
nor did there seem to be any particular reason for optimistic
expectations as to the near-term outlook. The analyst, however,
could not fail to be impressed by the balance sheet, which showed
net current assets available for the stock amounting to close to
$20 per share. The ten-year earnings, dividend and price record
of the common stock was as shown in the table on p. 517.

Certainly there is nothing attractive in this record, marked
as it is by irregularity and the absence of a favorable trend. But

companies in the heavy industries, e.g ., United States Steel, Bethlehem
Steel, American Locomotive.

l See Appendix Note 54, p. 780, for an example (Mack Trucks, Inc.)
used in the first edition of this work, together with its sequel.

ANALYSIS OF THE INCOME ACCOUNT

517

although these facts would undoubtedly condemn the issue in the
eyes of the speculator, the reasoning of the analyst might con¬
ceivably run along different lines.

Year

Earned per
share

Dividend paid

Price range

1938

mmm

0.45

12%- 8

1937

0.80

26 9

1936

1.42

0.75

22^-15

1935

0.75

0.40

16 - 6M

1934

0.21

10 - 5 H

1933

0.77(d)

nx- iX

1932

1.82(d)

7 - 2K

1931

0 56

1 00

18X- 4 X

1930

1.46

2.00

32 -12

1929

3.05

1.75

38%-17

Average 1934-1938

0.87

Average 1929-1938

0.68

The essential question for him would be whether or not the
company can be counted on to remain in business and to partici¬
pate about as before in good times and bad. On this point
consideration of the industry, the company's prominent position in
it and the strong financial set-up would clearly suggest an affirma¬
tive answer. If this were granted, the analyst would then point
out that the shares could be bought at 8 with very small chance
of ultimate loss and with every indication that under the next
set of favorable conditions the value of the stock would double.
Note that in 3 years out of the past 5 and in 6 out of the past 10,
the stock sold between 2 and 4 times the July 1930 price.

This type of reasoning, it will be noted, lays emphasis not
upon an accurate prediction of future trends but rather on reach¬
ing the general conclusion that the company will continue to do
business pretty much as before.

Wall Street is inclined to doubt that any such presumption
may be applied to companies with an irregular trend, and to con¬
sider that it is just as difficult and hazardous to reach a conclusion
of this kind as to determine that a “growing company" will con¬
tinue to grow. But in our view the Intertype form of reasoning
has two definite advantages over the customary attitude, e.g. y
that which would prefer a company such as Coca-Cola, at 22

518

SECURITY ANALYSIS

times recent earnings and 35 times its asset value, because of the
virtually uninterrupted expansion of its profits for more than
15 years.

The first advantage is that, after all, private business is con¬
ducted and investments made therein on the same kind of
assumptions that we have made with respect to Intertype. The
second is that reasoning of this kind can be conservative in that it
allows for a liberal margin of safety in case of error or disappoint¬
ment. It runs considerably less risk of confusion between
“confidence in the future” and mere speculative enthusiasm.

Large Profits Frequently Transitory.—More frequently we
have the opposite type of situation from that just discussed.
Here the analyst finds reason to question the indefinite con¬
tinuance of past prosperity.

Examples: Consider a company like J. W. Watson (“Stabi-
lator”) Company, engaged chiefly in the manufacture of a single
type of automotive accessory. The success of such a “gadget”

The J. W. Watson Company

Year

Net for common

Per diarc

Trice range for
common

Dividend

1932

$214,020(d)

C 1 07(d)

a / i /

>8“ 73

None

1931

240, 1 >,!){<:)

1.20(d)

O 1 /

" - 73

None

1930

26 4,200(d)

1.31(d)

G - 1

None

1929

S23,137{'’.)

1.01(d)

147S- l H

None

1928

348,030(d)

1.74(d)

20 - 5Ji

50 cents

1927

503,725

2.10

255*-18J$

50 cents

1926

577,450*

2 88*

(Issue not quoted

1925

502,593 *

2 51*

prior to 1927)

1924

29,2S5 *

0 15*

1923

173,907*

0 80 '

1922

142,701*

0 71 1

* Earnings are for predecessor companies, applied to 1932 capitalization.

is normally short-lived; competition and changes in the art are
an ever present threat to the stability of earning power. Hence
in such a case the student could have pointed out that the
market price, bearing the usual ratio to current and average
earnings, reflected a quite unwarranted confidence in the per¬
manence of profits that by their nature were likely to be transi-

ANALYSIS OF THE INCOME ACCOUNT

519

tory. Some of the pertinent data relative to this judgment are
given in the table on p. 518, with respect to this company. 1

A similar consideration would apply to the exhibit of Coty,
Inc., in 1928. Here was a company with an excellent earnings
record, but the earnings were derived from the popularity of a
trade-marked line of cosmetics. This was a field in which the
variable tastes of femininity could readily destroy profits as well
as build them up. The inference that rapidly rising profits in
previous years meant much larger profits in the future was thus
especially fallacious in this case, because by the nature of the
business a peak of popularity was likely to be reached at some
not distant point, after which a substantial falling off would be,
if not inevitable, at least highly probable. Some of the data
appearing on the Coty exhibit arc as follows:

Year

Net income

! K.irncd per share
(adjusted)

1923

51,070,000

$0 86

1924

2,016,000

1.66

1925

2,505,000

2.02

1926

2,943,000

2.38

1927

3,311,000

2.70

1928

4,047,000

3.09

1929

4,058,000

2.73

At the high price of 82 in 1929, Coty, Inc., was selling in the
market for about $120,000,000, or thirty times its maximum
earnings. The actual investment in the business (capital and
surplus) amounted to about $14,000,000.

Subsequent earnings were as shown in the table on p. 520.

A third variety of this kind of reasoning could be applied to the
brewcrv-stock flotations in 1933. These issues showed sub¬
stantial current or prospective earnings based upon capacity

1 The common stock of the company was originally offered in September
1927 at $21.50 per share, a price 17.3 times the average earnings of the
predecessor companies during the preceding five years. This relatively
high price wa 3 accounted for in part by the apparently favorable “ trend"
of oarning 3 , in part by the high recent and current earnings and in part
by the reckless standards of appraisal beginning to prevail at the time.

See pp. 438-440 of tho 1934 edition of this work for a companion case—
The Gabriel Company.

620

SECURITY ANALYSIS

operations and the indicated profit per barrel. Without claiming
the gift of second sight, an analyst could confidently predict
that the flood of capital being poured into this new industry
would ultimately result in overcapacity and keen competition.

Cott, Inc.

Year

Net income

Earned per share

1930

$1,318,000

$0.86

1931

991,000

0.65

1932

521,000

0.34 (low price in 1932-1^)

Hence a continued large return on the actual cash investment
was scarcely probable; it was likely, moreover, that many of the
individual companies would prove financial failures, and most
of the others would be unable to earn enough to justify the
optimistic price quotations engendered by their initial success. 1

1 See Appendix Note 55, p. 782, for brief comments on the subsequent
performance of the brewery issues of 1933.

CHAPTER XXXVIII

SPECIFIC REASONS FOR QUESTIONING OR
REJECTING THE PAST RECORD

In analyzing an individual company, each of the governing
elements in the operating results must be scrutinized for signs
of possible unfavorable changes in the future. This procedure
may be illustrated by various examples drawn from the mining
field. The four governing elements in such situations would be:
(1) life of the mine, (2) annual output, (3) production costs and
(4) selling price. The significance of the first factor has already
been discussed in connection with charges against earnings for
depletion. Both the output and the costs may be affected
adversely if the ore to be mined in the future differs from that
previously mined in location, character or grade. 1

Rate of Output and Operating Costs.— Examples: Calumet and
Hecla Consolidated Copper Company .—The reports of this copper
producer for 1936 and previous years illustrate various questions
with respect to ore reserves. The income account for 1936 may
be summarized as follows:

Copper produced. 78,500,000 lb.

Copper sold. 95,200,000 1b. @9.80 cents

Profit before depreciation and depletion. .. . S3,855,000

Depreciation. 1,276,000

Depletion . 1,726,000

Earned per share after depreciation but before
depletion on 2,006,000 shares. SI.29

Early in 1937 the stock sold at $20 per share, a valuation of
$40,000,000 for the company, or $30,000,000 for the mining
properties plus $10,000,000 for the working capital.

1 When ore reserves are stated only as so many tons, or so many years of
life, these data may be misleading in the absence of assurance regarding the
quality of ore remaining. Example: The depletion charges of Alaska
Juneau Gold Mining Company suggested a remaining life of some 85 years
from 1934. The registration statement however, claimed only some 25
years of life from 1934. The implication (confirmed upon inquiry) is that
the longer “life” included much low-grade ore of noncommercial character.

521

522

SECURITY ANALYSIS

A detailed analysis of the make-up of the 1936 earnings would
have shown them to be derived from four separate sources,
approximately as follows:

Source of copper

Number

pounds,

millions

Profit before d
dep]

Cents per
pound

(approximate)

lepreciation and
letion

Total

(approximate)

Copper previously produced. . .

17.3

4.5

$ 775,000

Conglomerate mine.

36.3

3.6

1,305,000

Ahmeek mine.

23.0

3.3

760,000

Reclamation plants.

19.2

5 3

1,015,000

95.8

4.0

S3,855,000

Of these four sources of profit, all but the smallest were defi¬
nitely limited in life. The sale of copper produced in prior years
was obviously nonrecurring. The mainstay of the company’s
production for 70 years—the Conglomerate Branch—was facing
exhaustion “in the course of 12 or 14 months.” The reclama¬
tion-plant copper, recovered by reworking old tailings and
providing the cheapest metal, was limited to a life of 5 to 7 years.
There remained as the only more permanent source of future
output the Ahmeek Mine, which was the highest cost operation
and which had therefore been shut down from April 1932 through
1935. (There were also certain other high-cost properties that
were still shut down in 1936.)

Analysis would indicate, therefore, that probably not more
than a total of some 7 to 8 millions in profit could be expected
in the future from the Conglomerate and the reclamation opera¬
tions. Hence, aside from new developments of a speculative
character, the greater part of the 40 millions of valuation for the
company would have to be supported by earnings from higher
cost properties which had contributed only a minor part of the 1936
results. 1

1 In the 1934 edition of this book we discussed a similar situation existing
in this company in 1927, at which time the largest part of the profits were
being contributed by the reclamation-plant operations, which were known
to have a limited life.

ANALYSIS OF THE INCOME ACCOUNT

523

Freeport Sulphur Company .—The exhibit of the then Freeport
Texas Company in 1933 supplies the same type of problem
for the analyst, and it also raises the question of the propriety
of the use, under such circumstances, of the past earnings record
to support the sale of new securities. An issue of $2,500,000
of 6% cumulative convertible preferred stock was sold at $100
per share in January 1933 in order to raise funds to equip a new
sulphur property leased from certain other companies.

The offering circular stated among other things:

1. That the sulphur reserves had an estimated life of at least 25 years
based upon the average annual sales for 1928-1932;

2. That the earnings for the period 1928-1932 averaged $2,952,500, or
19.6 times the preferred-dividend requirement.

The implication of these statements would be that, assuming
no change in the price received for sulphur, the company could
confidently be expected to earn over the next 25 years approxi¬
mately the amounts earned in the past.

The facts in the case, however, did not warrant any such deduc¬
tion. The company’s past earnings were derived from the
operation of two properties, at Bryanmound and at Hoskins
Mound, respectively. The Bryanmound area was owned by the
company and had contributed the bulk of the profits. But by
1933 its life was “definitely limited” (in the words of the listing
application); in fact the reserves were not likely to last more than
about three years . The Hoskins Mound was leased from the
Texas Company. After paying $1.06 per ton fixed royalty, no
less than 70% of the remaining profits were payable to Texas
Company as rental. 1 One half of Freeport's sales were required
to be made from sulphur produced at Hoskins. The new prop¬
erty at Grande Ecaille, La., now to be developed, would require
royalty payments amounting to some 40% of the net earnings.

When these facts are studied, it will be seen that the earnings
of Freeport Texas for 1928-1932 had no direct bearing on the
results to be expected from future operations. The sulphur

1 The rate had been 50 % until Freeport recouped its capital expenditures
on the property. Illustrative of the general theme of this chapter is the
break in Freeport’s price from 109 % to 65% in January-February 1928
coincident with the change in the royalty rate. The student may examine
a similar development in the case of Texas Gulf Sulphur, occurring in
1934-1935.

524

SECURITY ANALYSIS

reserves, stated to be good for 25 years, represented mineral
located in an entirely different place and to be extracted under
entirely different conditions from those obtaining in the past.
A large profit-sharing royalty would be payable on the sulphur
produced from the new project, whereas the old Bryanmound was
owned outright by Freeport and hence its profits accrued 100%
to the company.

In addition to this known element of higher cost, great stress
must be laid also upon the fact that the major future profits of
Freeport were now expected from a new project . The Grande
Ecaille property was not yet equipped and in operation, and
hence it was subject to the many hazards that attach to enter¬
prises in the development stage. The cost of production at the
new mine might conceivably be much higher, or much lower, than
at Bryanmound. From the standpoint of security analysis the
important point is that, where two quite different properties
are involved, you have two virtually separate enterprises. Hence
the 1928-1932 record of Freeport Texas was hardly more relevant
to its future history than were the figures of some entirely
different sulphur company, e.g ., Texas Gulf Sulphur.

Returning once more to the business man’s viewpoint on
security values, the Freeport Texas exhibit suggests the following
interesting line of reasoning. In June 1933 this enterprise was
selling in the market for about $32,000,000 (25,000 shares of
preferred at 125 and 730,000 shares of common at 40). The
major portion of its future profits were expected to be derived
from an investment of $3,000,000 to equip a new property leased
from three large oil companies. Presumably these oil companies
drove as good a bargain for themselves as possible in the terms
of the lease. The market was in effect placing a valuation of
some $20,000,000, or more, upon a new enterprise in which only
$3,000,000 was to be invested. It was possible, of course, that
this enterprise would prove to be worth much more than six
times the money put into it. But from the standpoint of ordi¬
nary business procedure the payment of such an enormous
premium for anticipated future results would appear imprudent
in the extreme. 1

1 Since the Freeport Texas preferred issue was relatively small, represent¬
ing less than one-tenth of the total market value of the company, this
analysis would not call into question the safety of the senior issue, but

ANALYSIS OF THE INCOME ACCOUNT

525

Evidently the stock market—like the heart, in the French
proverb—has reasons all its own. In the writers' view, where
these reasons depart violently from sound sense and business
experience, common-stock buyers must inevitably lose money
in the end, even though large speculative gains may temporarily
accrue, and even though certain fortunate purchases may turn
out to be permanently profitable.

The Future Price of the Product. —The three preceding
examples related to the future continuance of the rate of output
and the operating costs upon which the past record of earnings
was predicted. We must also consider such indications as may be
available in regard to the future selling price of the product.
Here we must ordinarily enter into the field of surmise or of
prophecy. The analyst can truthfully say very little about
future prices, except that they fall outside the realm of sound
prediction. Now and then a more illuminating statement may
be justified by the facts. Adhering to the mining field for our
examples, we may mention the enormous profits made by zinc
producers during the Great War, because of the high price of
spelter. Butte and Superior Mining Company earned no less
than $64 per share before depreciation and depletion in the two
years 1915-1916, as the result of obtaining about 13 cents per
pound for its output of zinc, against a prewar average of about
5cents. Obviously the future earning power of this company
was almost certain to shrink far below the war-time figures, nor
could these properly be taken together with the results of any
other years in order to arrive at the average or supposedly
“normal” earnings. 1

Change in Status of Low-cost Producers .—The copper-mining
industry offers an example of wider significance. An analysis
of companies in this field must take into account the fact that
since 1914 a substantial number of new low-cost producers have

reflects only upon the soundness of the valuation accorded the common
stock—judged by investment standards. After 1933 the company did in
fact encounter serious problems of production, which held down the earnings
and depressed the market price, but these problems were later solved.
Yet the maximum earnings attained by 1940—$3.30 per share in 1937—
could scarcely justify the price of 49 paid by speculators in 1933.

1 The same type of reasoning clearly applies to the volume of business due
to war conditions, as well illustrated by the exhibits of airplane companies
in 1939-1940.

526

SECURITY ANALYSIS

been developed and that other companies have succeeded in
reducing extraction costs through metallurgical improvements.
This means that there has been a definite lowering of the “ center
of gravity ” of production costs for the entire industry. Other
things being equal, this would make for a lower selling price in
the ‘future than obtained in the past. (Such a development is
more strikingly illustrated by the crude-rubber industry.)
Differently stated, mines that formerly rated as low-cost pro¬
ducers, i.e.y as having costs well below the average, may have
lost this advantage, unless they have also greatly improved their
technique of production. The analyst would have to allow for
these developments in his calculations, by taking a cautious
view of future copper prices—at least as compared with the
prewar or the predepression average. 1

Anomalous Prices and Price Relationships in the History of
the I.R.T. System. —The checkered history of the Interborough
Rapid Transit System in New York City has presented a great
variety of divergences between market prices and the real or
relative values ascertainable by analysis. Two of these dis¬
crepancies turn upon the fact that for specific reasons the then
current and past earnings should not have been accepted as
indicative of future earning power. In abbreviated form the
details of these two situations are as follows:

For a number of years prior to 1918 the Interborough Rapid
Transit Company was very prosperous. In the 12 months
ended June 30, 1917, it earned $26 per share on its capital stock
and paid dividends of $20 per share. Nearly all of this stock was
owned by Interborough Consolidated Corporation, a holding
concern (previously called Interborough-Metropolitan Corpora¬
tion) which in turn had outstanding collateral trust bonds,
6% preferred stock and common stock. Including its share of
the undistributed earnings of the operating company it earned
about $11.50 per share on its preferred stock and about $2.50 on
the common. The preferred sold in the market at 60, and the
common at 10. These issues were actively traded in, and they
were highly recommended to the public by various financial

1 On the other hand, the rise in the price of gold in 1933 invalidated for
statistical purposes previous earnings of gold producers based on $20.67 gold.
Whether or not the future price of gold will remain at $35 is anyone’s guess,
but there seems no reason to make any calculations based on the old value.

ANALYSIS OF THE INCOME ACCOUNT 527

agencies which stressed the phenomenal growth of the subway
traffic.

A modicum of analysis would have shown that the real picture
was entirely different from what appeared on the surface. New
rapid transit facilities were being constructed under contract
between the City of New York and the Interborough (as well as
others under contract between the City and the Brooklyn Rapid
Transit Company). As soon as the new lines were placed in
operation, which was to be the following year, the earnings avail¬
able for Interborough were to be limited under this contract to the
figure prevailing in 1911-1913, which was far less than the current
profits . The City would then be entitled to receive a high return
on its enormous investment in the new lines. If and after all
such payments were made in full, including back accruals, the
City and the Interborough would then share equally in surplus
profits. However, the preferential payments due the City would
be so heavy that experts had testified that under the most favor¬
able conditions it would be more than 30 years before there could
be any surplus income to divide with the company.

The subjoined brief table shows the significance of those facts.

Interborougii Rapid Transit System

Item

Actual

earnings

1917

Maximum earnings
when contract with
City became
operative

Balance for I.R.T. stock.

Share applicable to Interborough Consoli¬

39,100,000

85,200,000

dated Corp.

8,800,000

5,000,000

Interest on Inter. Consol, bonds. ...

3,520,000

Balance for Inter. Consol, pfd....

5,280,000

1,4S0,000

Preferred dividend requirements.. .

2,740,000

Balance for Inter. Consol, common.. .

2,540,000

1 y 260,000(d)

Earned per share, Inter. Consol, pfd.

$11.50

83.25

Earned per share, Inter. Consol, common..

2.50

nil

The underlying facts proved beyond question, therefore, that
instead of a brilliant future being in store for Interborough, it was
destined to suffer a severe loss of earning power within a year’s
time. It would then be quite impossible to maintain the $6
dividend on the holding company’s preferred stock, and no

528

SECURITY ANALYSIS

earnings at all would bo available for the common for a generation
or more. On this showing it was mathematically certain that
both Interborough Consolidated stock issues were worth far
less than their current selling prices. 1

The sequel not only bore out this criticism, which it was
bound to do, but demonstrated also that where an upper limit
of earnings or value is fixed, there is usually danger that the
actual figure will be less than the maximum. The opening of the
new subway lines coincided with a large increase in operating
costs, due to war-time inflation; and also, as was to be expected,
it diminished the profits of the older routes. Interborough Rapid
Transit Company was promptly compelled to reduce its dividend,
and it was omitted entirely in 1919. In consequence the holding
company, Interborough Consolidated, suspended its preferred
dividends in 1918. The next year it defaulted the interest on
its bonds, became bankrupt and disappeared from the scene, with
the complete extinction of both its preferred and common stock. Two
years later Interborough Rapid Transit Company, recently so
prosperous, barely escaped an imminent receivership by means of a
“ voluntary ” reorganization which extended a maturing note issue.
When this extended issue matured in 1932, the company was again
unable to pay, and this time receivers took over the property.

During the ten-year period between the two receivership
applications another earnings situation developed, somewhat
similar to that of 1917. 2 In 1928 the Interborough reported

1 Indications pointed strongly to manipulative efforts by insiders in 1916-
1917 to foist these shares upon the public at high prices before the period
of lower earnings began. The payment of full dividends on the preferred
stock, during an interlude of large earnings known to be temporary, was
inexcusable from the standpoint of corporate policy but understandable
as a device to aid in unloading stock. These dividend distributions were
not only unfair to the % bondholders, but, because of certain prior
developments, they were probably illegal as well. (Reference to this
aspect of the case was made in Chap. XX).

a See Appendix Note 56, p. 782, for a concise discussion of the numerous
anomalies in price between various Interborough System securities, viz.:

1. Between Interborough Metropolitan 43^s and Interborough Con¬
solidated Preferred in 1919.

2. Between I.R.T. 5s and I.R.T. 7s in 1920.

3. Between I.R.T. stock and Manhattan “Modified” stock in 1929.

4. Between I.R.T. 5s and I.R.T. 7s in 1933.

6. Between Manhattan “Modified” and Manhattan “Unmodified”
stock in 1933.

ANALYSIS OF THE INCOME ACCOUNT

529

earnings of $3,000,000, or $8.50 per share for its common stock,
and the shares sold as high as 62. But these earnings included
$4,000,000 of “back preferentials” from the subway division.
The latter represented a limited, amount due the Interborough
Rapid Transit out of subway earnings to make good a deficiency
in the profits of the early years of operating the new lines. On
June 30, 1928 the amount of back preferentials remaining to be
paid the company was only $1,413,000. Hence all the profits
available for Interborough stock were due to a special source of
revenue that could continue for only a few months longer. Heedless
speculators, however, were capitalizing as permanent an earning
power of Interborough stock which analysis would show was of
entirely nonrecurrent and temporary character.

CHAPTER XXXIX

PRICE-EARNINGS RATIOS FOR COMMON STOCKS.
ADJUSTMENTS FOR CHANGES IN CAPITALIZATION

In previous chapters various references have been made to Wall
Street’s ideas on the relation of earnings to values. A given
common stock is generally considered to be worth a certain
number of times its current earnings. This number of times, or
multiplier, depends partly on the prevailing psychology and
partly on the nature and record of the enterprise. Prior to the
1927-1929 bull market ten times earnings was the accepted
standard of measurement. More accurately speaking, it was
the common point of departure for valuing common stocks, so
that an issue would have to be considered exceptionally desirable
to justify a higher ratio, and conversely.

Beginning about 1927 the ten-times-earnings standard was
superseded by a rather confusing set of new yardsticks. On
the one hand, there was a tendency to value common stocks in
general more liberally than before. This was summarized in a
famous dictum of a financial leader implying that good stocks
were worth fifteen times their earnings. 1 There was also the
tendency to make more sweeping distinctions in the valuations
of different kinds of common stocks. Companies in especially
favored groups, e.g. y public utilities and chain stores, in 1928-
1929, sold at a very high multiple of current earnings, say,
twenty-five to forty times. This was true also of the “blue chip”
issues, which comprised leading units in miscellaneous fields.
As pointed out before, these generous valuations were based upon
the assumed continuance of the upward trend shown over a

1 The wording of this statement, as quoted in the Wall Street Journal of
March 26, 1928, was as follows: “ 1 General Motors shares, according to the
Dow, Jones & Co. averages/ Mr. Raskob remarked, ‘should sell at fifteen
times earning power, or in the neighborhood of $225 per share, whereas at
the present level of $180 they sell at approximately only twelve times
current earnings.’ ”

630

ANALYSIS OF THE INCOME ACCOUNT

531

longer or shorter period in the past. Subsequent to 1932 there
developed a tendency for prices to rule higher in relation to
earnings because of the sharp drop in long-term interest rates.

Exact Appraisal Impossible. —‘Security analysis cannot presume
to lay down general rules as to the “proper value” of any given
common stock. Practically speaking, there is no such thing.
The bases of value are too shifting to admit of any formulation
that could claim to be even reasonably accurate. The whole
idea of basing the value upon current earnings seems inherently
absurd, since we know that the current earnings are constantly
changing. And whether the multiplier should be ten or fifteen or
thirty would seem at bottom a matter of purely arbitrary choice.

But the stock market itself has no time for such scientific
scruples. It must make its values first and find its reasons
afterwards. Its position is much like that of a jury in a breach-
of-promise suit; there is no sound way of measuring the values
involved, and yet they must be measured somehow and a verdict
rendered. Hence the prices of common stocks are not carefully
thought out computations but the resultants of a welter of human
reactions. The stock market is a voting machine rather than a
weighing machine. It responds to factual data not directly
but only as they affect the decisions of buyers and sellers.

Limited Functions of the Analyst in Field of Appraisal of Stock
Prices. —Confronted by this mixture of changing facts and
fluctuating human fancies, the securities analyst is clearly incap¬
able of passing judgment on common-stock prices generally.
There are, however, some concrete, if limited, functions that
he may carry on in this field, of which the following arc
representative:

1. He may set up a basis for conservative or investment valuation of com¬
mon stocks, as distinguished from speculative valuations.

2. He may point out the significance of: (a) the capitalization structure;
and ( b ) the source of income, as bearing upon the valuation of a given stock
issue.

3. He may find unusual elements in the balance sheet which affect the
implications of the earnings picture.

A Suggested Basis of Maximum Appraisal for Investment.—

The investor in common stocks, equally with the speculator, is
dependent on future rather than past earnings. His fundamental
basis of appraisal must be an intelligent and conservative esti-

532

SECURITY ANALYSIS

mate of the future earning power. But his measure of future
earnings can be conservative only if it is limited by actual per¬
formance over a period of time. We have suggested, however,
that the profits of the most recent year, taken singly, might be
accepted as the gage of future earnings, if (1) general business
conditions in that year were not exceptionally good, (2) the com¬
pany has shown an upward trend of earnings for some years
past and (3) the investor’s study of the industry gives him con¬
fidence in its continued growth. In a very exceptional case, the
investor may be justified in counting on higher earnings in the
future than at any time in the past. This might follow from
developments involving a patent or the discovery of new ore in a
mine or some similar specific and significant occurrence. But
in most instances he will derive the investment value of a com¬
mon stock from the average earnings of a period between five
and ten years. This does not mean that all common stocks
with the same average earnings should have the same value.
The common-stock investor (i.e., the conservative buyer) will
properly accord a more liberal valuation to those issues which
have current earnings above the average or which may reasonably
be considered to possess better than average prospects or an
inherently stable earning power. But it is the essence of our
viewpoint that some moderate upper limit must in every case
be placed on the multiplier in order to stay within the bounds
of conservative valuation. We would suggest that about 20
times average earnings is as high a price as can be paid in an
investment purchase of a common stock.

Although this rule is of necessity arbitrary in its nature, it is not
entirely so. Investment presupposes demonstrable value, and
the typical common stock’s value can be demonstrated only by
means of an established, i.e. } an average, earning power. But it is
difficult to see how average earnings of less than 5% upon the
market price could ever be considered as vindicating that price.
Clearly such a price-earnings ratio could not provide that margin
of safety which we have associated with the investor’s position.
It might be accepted by a purchaser in the expectation that future
earnings will be larger than in the past. But in the original and
most useful sense of the term such a basis of valuation is specula¬
tive. 1 It falls outside the purview of common-stock investment.

1 See Appendix Noto 57, p. 784, for a discussion of the relationship
between bond-interest rates and the “multiplier” for common stocks.

ANALYSIS OF THE INCOME ACCOUNT

533

Higher Prices May Prevail for Speculative Commitments .—
The intent of this distinction must be clearly understood. We do
not imply that it is a mistake to pay more than 20 times average
earnings for any common stock*. We do suggest that such a
price would be speculative. The purchase may easily turn out
to be highly profitable, but in that case it will have proved a
wise or fortunate speculation. It is proper to remark, moreover,
that very few people are consistently wise or fortunate in their
speculative operations. Hence we may submit, as a corollary
of no small practical importance, that people who habitually
purchase common stocks at more than about 20 times their average
earnings are likely to lose considerable money in the long run . This
is the more probable because, in the absence of such a mechanical
check, they are prone to succumb recurrently to the lure of bull
markets, which always find some specious argument to justify
paying extravagant prices for common stocks.

Other Requisites for Common Stocks of Investment Grade and a
Corollary Therefrom .—It should be pointed out that if 20 times
average earnings is taken as the upper limit of price for an invest¬
ment purchase, then ordinarily the price paid should be sub¬
stantially less than this maximum. This suggests that about 12
or 123^2 times average earnings may be suitable for the typical
case of a company with neutral prospects. We must emphasize
also that a reasonable ratio of market price to average earnings
is not the only requisite for a common-stock investment. It is a
necessary but not a sufficient condition. The company must be
satisfactory also in its financial set-up and management, and
not unsatisfactory in its prospects.

From this principle there follows another important corollary,
viz.: An attractive common-stock investment is an attractive specula¬
tion. This is true because, if a common stock can meet the
demand of a conservative investor that he get full value for his
money plus not unsatisfactory future prospects, then such an
issue must also have a fair chance of appreciating in market value.

Examples of Speculative and Investment Common Stocks.—
Our definition of an investment basis for common-stock purchases
is at variance with the Wall Street practice in respect to common
stocks of high rating. For such issues a price of considerably
more than 20 times average earnings is held to be warranted,
and furthermore these stocks are designated as “investment
issues” regardless of the price at which they sell. According to

534

SECURITY ANALYSIS

our view, the high prices paid for “the best common stocks"
make these purchases essentially speculative, because they
require future growth to justify them. Hence common-stock
investment operations, as we define them, will occupy a middle
ground in the market, lying between low-price issues that are
speculative because of doubtful quality and well-entrenched

Group A: Common Stocks Speculative in December 1938 Because of

Their High Price

(Figures adjusted to reflect changes in capitalization)

Item

Guoup A

General Electric

Coca Cola

Johns-Manville

Amount Earned per Share
of Common:

1938.

$0 96

$5 95

$1.09

1937 .

2.20

5.73

5.80

1936 .

1.52

4.66

5 13

1935 .

0.97

3 48

2.17

1934.

0 59

3.12

0 22

1933 .

0 38

2 20

0.64(d)

1932 .

0.41

2.17

4 47(d)

1931.

1.33

2 96

0 45

1930 .

1 90

2.79

3 60

1929 .

2 24

2 56

8 09

10-yr. average .

5-yr. average (1934-

$1 25

$3.56

$2.15

1938) ..

SI. 25

$4.59

$2 88

Bonds .

None

Pfd. Stock...

None

600,000 sh. @ GO
$ 36,000,000

75,000 sh. <& 13(
$ 9,750,000

Common Stock.

28.784,000 sh. @ 43H
$1,230,000,000

3,992,000 sh. (ft 132H
$529,500,000

850,000 sh. (<j) 10‘
89,300,000

Total capitalization.

Net tangible assets,

$1,250,000,000

$565,500,000

$99^050,000

12/31/38 .

Net current assets,

$ 335,182,000

$43,486,000

$48,001,000

12/31/38.

Average earnings on com¬
mon-stock price, 1929-

S 155,023,000

$25,094,000

$17,418,000

1938 .

Maximum earnings on com¬
mon-stock price, 1929-

2.9%

2.7%

2.0%

1938.

Minimum earnings on com¬
mon-stock price, 1929-

5.1%

4.5%

7 7%

1938 .

Average earnings on com¬
mon-stock price, 1934-

0.9%

1.6%

(d)

1938.

2.9%

3.5%

2.7%

ANALYSIS OF THE INCOME ACCOUNT

535

issues that are speculative, none the less, because of their high
price.

These distinctions are illustrated by 1 the accompanying nine
examples, taken as of December 31, 1938.

Comments on the Various Groups .—The companies listed in
Group A are representative of the so-called first-grade or “blue
chip” industrials, which were particularly favored in the great
speculation of 1928-1929 and in the markets of ensuing years.
They are characterized by a strong financial position, by pre¬
sumably excellent prospects and in most cases by relatively

Group B: Common Stocks Speculative in December 1938 Because of
Their Irregular Record

Item

Group B

Goodyear Tire
and Rubber

Simmons

Youngstown Sheet
and Tube

Amount earned per share

of common:

1938

$ 1 34

$1 42

$ O 89(d)

1937

1 95

2 88

6 79

1936

3 90

3 53

7 03

1935

0 12

1 14

0 64

1934

0 6G(d)

0 84(d)

2 95(d)

1933

0 79(d)

0 04

7 7 6(d)

1932

4 24(d)

2 57(d)

11 75(d)

1931

0 04

0 79(d)

6 55(d)

1930

0.57(d)

1 05(d)

5 17

1929

10 23

4 15

17 28

10-yr. average .

$ 1 15

$0 79

$ 0 70

5-yr. average (1934-

1938) .

$ 1 35

$1 63

$ 2 12

Bonds . ....

$ 50.235,000

$10,000,000

$ 87,000,000

Pfd. stock .

650,000 sh. @ 103

None

150,000 sh. ® 81

70,250,000

12,165,000

Common stock.

2,059,000 sh. ®37*$

1,158,000 sh. @32

1,675,000 sh. @ 54>4

77,500,000

37,050,000

90.900,000

Total capitalization.

$197,985,000

$47,050,000

$190,065,000

Net tangible assets, 12/31/38

$170,322,000

$28,446,000

$224,678,000

Net current assets, 12/31/38

$ 96,979,000

$14,788,000

$ 83,375,000

Average earnings on com¬

mon-stock price, 1929-1938

3.1%

2 5%

1 3%

Maximum earnings on com¬

mon-stock price, 1929-1938

27 2%

13 0%

31 8%

Minimum earnings on com¬

mon-stock price, 1929-1938

(d)

Average earnings on com¬

mon-stock price, 1934-1938

3 6%

5 1%

3.9%

1 See Appendix Note 58, p. 785, for the examples given in the 1934
edition, and their later performance.

536

SECURITY ANALYSIS

stable or growing earnings in the past. The market price of the
shares, however, was higher than would be justified by their
average earnings. In fact the profits of the best year in the 1929-
1938 decade were less than 8% of the December 1938 market
price. It is also characteristic of such issues that they sell for
enormous premiums above the actual capital invested.

The companies analyzed in Group B are obviously speculative,
because of the great instability of their earnings records. They
show varying relationships of market price to average earnings,
maximum earnings, and asset values.

Group C: Common Stocks Meeting Investment Tests in December 1938
from the Quantitative Standpoint

Group C

Item

Adams-Millis

American Safety
Razor

J. J. Newberry

Amount earned per share of
common*

1938

S3.21

SI. 48

S4.05

1937

2 77

2.47

5.27

1936

2 55

2.70

6.03

1935

2.93

2 42

4 94

1934

3 41

2 03

5 38

1933

2 63

1.40

3 06

1932

1 03

1.14

1.07

1931

4 72

1 58

1.73

1930

4 83

2 50

2 27

1929

4 83

2 57

3 15

10 -yr. average.

S3.29 .

$2 03

S3 70

5-yr. average (1934-1938) ..

S2 97 |

S2 22

$5 13

Bonds.

None !

None

S 5,587,000

Pfd. stock.

None

51,000 sh. @ 106
5,405,000

Common stock.

156,000 sh. @ 21
S3,280,000

524,000 sh. @ IVA
$7,800,000

380,000 sh. @ 34M
13,110,000

Total capitalization.

S3,280,000

$7,800,000

$24,102,000

Net tangible assets, 12/31/38. .

$3,320,000

$6,484,000

$25,551,000

Net current assets, 12/31/38 . .

S 926,000

$3,649,000

S 8,745,000

Average earnings on common-

stock price, 1929-1938 .

15.7%

13.7%

10.7%

Maximum earnings on common-

stock price, 1929-1938.

23.0%

18.2%

17.5%

Minimum earnings on common-

stock price, 1929-1938.

4.9%

7.7%

8.1%

Average earnings on common-

stock price, 1934-1938.

14.1%

14.9%

ANALYSIS OF THE INCOME ACCOUNT

537

The common stocks shown in Group C are examples of those
which meet specific and quantitative tests of investment quality.
These tests include the following:

1. The earnings have been reasonably stable, allowing for the tremendous
fluctuations in business conditions during the ten-year period.

2. The average earnings bear a satisfactory ratio to market price. 1

3. The financial set-up is sufficiently conservative, and the working-
capital position is strong.

Although we do not suggest that a common stock bought foi
investment be required to show asset values equal to the price
paid, it is none the less characteristic of issues in Group C that,
as a whole, they will not sell for a huge premium above the
companies' actual resources.

Common-stock investment , as we envisage it, will confine itself
to issues making exhibits of the kind illustrated by Group C.
But the actual purchase of any such issues must require also
that the purchaser be satisfied in his own mind that the prospects
of the enterprise are at least reasonably favorable.

ALLOWANCES FOR CHANGES IN CAPITALIZATION

In dealing with the past record of earnings, when given on a
per-share basis, it is elementary that the figures must be adjusted
to reflect any important changes in the capitalization which have
taken place during the period. In the simplest case these will
involve a change only in the number of shares of common stock
due to stock dividends, split-ups, etc. All that is necessary then
is to restate the capitalization throughout the period on the basis
of the current number of shares. (Such recalculations are made
by some of the statistical services but not by others.)

When the change in capitalization has been due to the sale of
additional stock at a comparatively low price (usually through
the exercise of subscription rights or warrants) or to the conver¬
sion of senior securities, the adjustment is more difficult. In
such cases the earnings available for the common during the
earlier period must be increased by whatever gain would have
followed from the issuance of the additional shares. When
bonds or preferred stocks have been converted into common,

1 Note that the average earnings of the three companies in Group C
were nearly two and one-half times as large relative to market price as the
maximum earnings of the companies in Group A.

538

SECURITY ANALYSIS

the charges formerly paid thereon are to be added back to the
earnings and the new figure then applied to the larger number
of shares. If stock has been sold at a relatively low price, a
proper adjustment would allow earnings of, say, 5 to 8% on the
proceeds of the sale. (Such recalculations need not be made
unless the changes indicated thereby are substantial.)

A corresponding adjustment of the per-share earnings must be
made at times to reflect the possible future increase in the number
of shares outstanding as a result of conversions or exercise of
option warrants. When other security holders have a choice
of any kind, sound analysis must allow for the possible adverse
effect upon the per-share earnings of the common stock that
would follow from the exercise of the option.

Examples: This type of adjustment must be made in analyzing
the reported earnings of American Airlines, Inc., for the 12
months ended September 30, 1939.

Earnings as reported. $1,128,000

Per share on about 300,000 shares out¬
standing. $3.76

(Price December 1939 about 37)

But there were outstanding $2,600,000 of 4 Yi% debentures,
convertible into common slock at $12.50 per share. The
analyst must assume conversion of the bonds, giving the following
adjusted result:

Earnings, adding back $117,000 interest. $1,245,000

Per share on 508,000 shares. $2.45

More than one-third of the reported earnings per share arc
lost when the necessary adjustment is made.

American Water Works and Electric Company can be used to
illustrate both types of adjustment. (See page 539.)

Adjustment A reflects the payment of stock dividends in 1928,
1929 and 1930.

Adjustment B assumes conversion of the $15,000,000 of
convertible 5s, issued in 1934, thus increasing the earnings by
the amount of the interest charges but also increasing the com¬
mon-stock issue by 750,000 shares. (The foregoing adjustments
are independent of any possible modifications in the reported
earnings arising from the questioning of the depreciation charges,
etc., as previously discussed.)

ANALYSIS OF THE INCOME ACCOUNT

539

Year

Earnings* for
common
as reported

Adjustment

Adjustment B.

Amount

Num¬
ber of
shares

Per

]

Num¬
ber of
shares

Ear¬

ned

per

Amount

Num¬
ber of
shares

Ear¬

ned

per

1933

$2,392

1,751

$1.37

1,751

$1.37

$3,140

2,501

$1.26

1932

2,491

1,751

1.42

1,751

1.42

3,240

2,501

1.30

1931

4,904

1,751

2.80

1,751

2.80

5,650

2,501

2.26

1930

5,424

1,751

3.10

1,751

3.10

6,170

2,501

2.47

1929

6,621

1,657

4.00

1,741

3.80

7,370

2,491

2.95

1928

5,009

1,432

3.49

1,739

2.88

5,760

2,489

2 30

1927

3,660

1,737

2.11

4,410

2,487

1.76

7-year

average

$2.50

$2.04

* Number of shares and earnings in thousands.

Corresponding adjustments in book values or current-asset
values per share of common stock should be made in analyzing
the balance sheet. This technique is followed in our discussion
of the Baldwin Locomotive Works exhibit in Appendix Note 70,
page 822, in which outstanding warrants are allowed for.

ALLOWANCES FOR PARTICIPATING INTERESTS
In calculating the earnings available for the common, full
recognition must be given to the rights of holders of participating
issues, whether or not the amounts involved are actually being
paid thereon. Similar allowances must be made for the effect of
management contracts providing for a substantial percentage of
the profits as compensation, as in the case of investment trusts.
Unusual cases sometimes arise involving “ restricted shares/ 1
dividends on which are contingent upon earnings or other
considerations.

Example ; Trico Products Corporation, a large manufacturer of
automobile accessories, is capitalized at 675,000 shares of common
stock, of which 450,000 shares (owned by the president) were
originally “restricted” as to dividends. The unrestricted stock
is first entitled to dividends of $2.50 per share, after which both
classes share equally in further dividends. In addition, successive
blocks of the restricted stock were to be released from the restric-

540

SECURITY ANALYSIS

tion according as the earnings for 1925 and successive years
reached certain stipulated figures. (To the end of 1938, a total
of 239,951 shares had been thus released.)

Adjusted Earnings: Trico Products Corporation 1

Yew

Earnings

for

common

Earned per share on unrestricted stock

A. Ignoring
restricted
shares

B. Maximum
distribution

on un¬
restricted
shares

C. Allowing
for release
of restricted
shares (i.e.,
on total cap¬
italization)

1929

.32,250,000

86.67

$4 58

$3.33

1930

1,908,000

5.09

3.94

2.83

1931

1,763,000

4.70

3.72

2.61

1932

965,000

2.57

2 54

1.44

1933

1,418,000

3.78

3.21

2.10

1934

1,772,000

4.72

3.74

2.62

1935

3,567,000

9.84

6.52

5.38

1936

4,185,000

9.75

7.25

6.39

1937

3,792,000

8.97

6.82

5.99

1938

2,320,000

5 56

4.53

3.70

10-year average. ..

83,394,000

$6.17

$4.69

$3.64

1 The calculations for the years 1935-1938 have been affected by repurchases of unre¬
stricted shares by the corporation.

In the above table Column C supplies the soundest measure
of the earning power shown for the unrestricted shares. Column
A is irrelevant.

A situation similar to that in Trico Products Corporation
obtained in the case of Montana Power Company stock prior
to June 1921.

General Rule. —The material in the last few pages may be
summarized in the following general rule:

The intrinsic value of a common stock preceded by convertible securi¬
ties, or subject to dilution through the exercise of stock options or
through participating privileges enjoyed by other security holders,
cannot reasonably be appraised at a higher figure than would be justified
if all such privileges were exercised in full.

CHAPTER XL

CAPITALIZATION STRUCTURE

The division of a company’s total capitalization between
senior securities and common stock has an important bearing
upon the significance of the earning power per share. A set of
hypothetical examples will help make this point clear. For this
purpose we shall postulate three industrial companies, A, B and
C, each with an earning power (i.e., with average and recent
earnings) of $1,000,000. They are identical in all respects save
capitalization structure. Company A is capitalized solely at
100,000 shares of common stock. Company B has outstanding
$6,000,000 of 4% bonds and 100,000 shares of common stock.
Company C has outstanding $12,000,000 of 4% bonds and 100,-
000 shares of common stock.

We shall assume that the bonds are worth par and that the
common stocks are worth about 12 times their per-share earnings.
Then the value of the three companies will work out as follows:

Company

Earnings
for common
stock

Value of

common

stock

Value of
bonds

Total
value of
company

31,000,000

$12,000,000

760,000

9,000,000

$ 6,000,000

15,000,000

520,000

6,000,000 1

12,000,000

18,000,000

These results challenge attention. Companies with identical
earning power appear to have widely differing values, due solely
to the arrangement of their capitalization. But the capitaliza¬
tion structure is itself a matter of voluntary determination by
those in control. Does this mean that the fair value of an
enterprise can be arbitrarily increased or decreased by changing
around the relative proportions of senior securities and common
stock?

641

542

SECURITY ANALYSIS

Can the Value of an Enterprise Be Altered through Arbi¬
trary Variations in Capital Structure? —To answer this question
properly we must scrutinize our examples with greater care.
In working out the value of the three companies we assumed that
the bonds would be worth par and that the stocks would be
worth twelve times their earnings. Are these assumptions tenable ?
Let us consider first the case of Company B. If there arc no
unfavorable elements in the picture, the bonds might well sell
at about 100, since the interest is earned four times. Nor
would the presence of this funded debt ordinarily prevent
the common stock from selling at 12 times its established earning
power.

It will be urged however, that, if Company B shares arc worth
12 times their earnings, Company A shares should be worth
more than this multiple because they have no debt ahead of
them. The risk is therefore smaller, and they are less vulnerable
to the effect of a shrinkage in earnings than is the stock of Com¬
pany B. This is obviously true, and yet it is equally true that
Company B shares will be more responsive to an increase in
earnings. The following figures bring this point out clearly:

Assumed earnings

Earned per share

Change in earnings per
share from base

Co. A

Co. D

Co. A

Co. B

$1,000,000

$10.00

$ 7 60

(Base)

750,000

7 50

5.10

-25%

-33%

1,250,000

12 50

10.10

+25%

+33%

Would it not be fair to assume that the greater sensitivity of
Company B to a possible decline in profits is offset by its greater
sensitivity to a possible increase? Furthermore, if the investor
expects higher earnings in the future—and presumably he selects
his common stocks with this in mind—would he not be justified
in selecting the issue that will benefit more from a given degree
of improvement? We are thus led back to the original conclu¬
sions that Company B may be worth $3,000,000, or 25%, more
than Company A due solely to its distribution of capitalization
between bonds and stock.

ANALYSIS OF THE INCOME ACCOUNT

543

Principle of Optimum Capitalization Structure. —Paradoxical
as this conclusion may seem, it is supported by the actual
behavior of common stocks in the market. If we subject this
contradiction to closer analysis, we shall find that it arises from
what may be called an oversimplification of Company A’s capital
structure. Company -A’s common stock evidently contains
the two elements represented by the bonds and stock of Company
B . Part of Company A’s stock is at bottom equivalent to
Company B’ s bonds and should in theory be valued on the same
basis, i.e., 4%. The remainder of Company A’s stock should
then be valued at 12 times earnings. This theoretical reasoning
would give us a combined value of $15,000,000, i.e ., an average
6/6% basis, for the two components of Company A stock, which,
of course, is the same as that of Company B bonds and stock
taken together.

But this $15,000,000 value for Company A stock would not
ordinarily be realized in practice. The obvious reason is that the
common-stock buyer will rarely recognize the existence of a
“bond component” in a common-stock issue, and in any event,
not wanting such a bond component, he is unwilling to pay
extra for it. 1 This fact leads us to an important principle, both
for the security buyer and for corporate management, viz.:

The optimum capitalization structure for any enterprise includes
senior securities to the extent that they may safely be issued and
bought for investment.

Concretely this means that the capitalization arrangement of
Company B is preferable to that of Company A from the stock¬
holder’s standpoint, assuming that in both cases the $6,000,000
bond issue would constitute a sound investment. (This might
require, among other things, that the companies show a net

1 See our discussion of American Laundry Machinery Company on pp.
505-507 of the 1934 edition of this work for an illustration of the possible
effect of a change of capital structure from an all-stock to a stock-and-bond
combination. Actual changes of this kind were made by American Zinc
(through a dividend in preferred stock in 1910) and by Maytag Company
through similar distributions in 1928. The usual method of introducing a
speculative capitalization structure into a company with a conservative
set-up is through formation of a holding company that issues its own senior
securities and common stock against acquisition of the operating com¬
pany^ common. Examples: Chesapeake Corporation in 1927, Kaufmann
Department Stores Securities Corporation in 1925.

544

SECURITY ANALYSIS

working capital of not less than $6,000,000, in accordance with
the stringent tests for sound industrial issues recommended in
Chap. XIII.) Under such conditions the contribution of the
entire capital by the common stockholders may be called an
overconservative set-up, as it tends generally to make the stock¬
holder's dollar less productive to him than if a reasonable part
of the capital were borrowed. An analogous situation holds true
in most private businesses, where it is recognized as profitable
and proper policy to use a conservative amount of banking
accommodation for seasonal needs rather than to finance oper¬
ations entirely by owners' capital.

Corporate Practices Resulting in Shortage of Sound Industrial
Bonds.—Furthermore, just as it is desirable from the bank's
standpoint that sound businesses borrow seasonally, it is also
desirable from the standpoint of investors generally that strong
industrial corporations raise an appropriate part of their capital
through the sale of bonds. Such a policy would increase the
number of high-grade bond issues on the market, giving the
bond investor a wider range of choice and making it deservedly
difficult to sell unsound bonds. Unfortunately the practice of
industrial corporations in recent years has tended to produce a
shortage of good industrial bond issues. Strong enterprises have
in general refrained from floating new bonds and in many cases
have retired old ones. But this avoidance of bonded debt by
the strongest industrial companies has in fact produced results
demoralizing to investors and investment policies in a number of
ways. The following observations on this point, written in 1934,
are still applicable in good part:

1. It has tended to restrict new industrial-bond financing to companies
of weaker standing. The relative scarcity of good bonds impelled invest¬
ment houses to sell and investors to buy inferior issues, with inevitably
disastrous results.

2. The shortage of good bonds also tended to drive investors into the
preferred-stock field. For reasons previously detailed (in Chap. XIV)
straight preferred stocks are unsound in theory, and they are therefore
likely to prove unsatisfactory investment media as a class.

3. The elimination (or virtual elimination) of senior securities in the
set-up of many large corporations has, of course, added somewhat to the
investment quality of their common stocks, but it has added even more to
the investor's demand for these common stocks. This in turn has resulted
in a good deal of common-stock buying by people whose circumstances
required that they purchase sound bonds. Furthermore it has supplied a

ANALYSIS OF THE INCOME ACCOUNT

545

superficial justification for the creation of excessive prices for these common
stocks; and finally it contributed powerfully to that confusion between
investment motives and speculative motives which during 1927-1929
served to debauch so large a proportion of the country's erstwhile careful
investors.

Appraisal of Earnings Where Capital Structure Is Top-heavy.—

In order to carry this theory of capitalization structure a step
further, let us examine the case of Company C. We arrived at a
valuation of $18,000,000 for this enterprise by assuming that its
$12,000,000 bond issue would sell at par and the stock would
sell for 12 times its earnings of $5.20 per share. But this assump¬
tion as to the price of the bonds is clearly fallacious. Earn¬
ings of twice interest charges are not sufficient protection for an
industrial bond, and hence investors would be unwise to purchase
such an issue at par. In fact this very example supplies a useful
demonstration of our contention that a coverage of two times
interest is inadequate. If it were ample—as some investors
seem to believe—the owners of any reasonably prosperous
business, earning 8% on the money invested, could get back their
entire capital by selling a 4 % bond issue, and they would still have
control of the business together with one-half of its earnings.
Such an arrangement would be exceedingly attractive for the
proprietors but idiotic from the standpoint of those who buy
the bonds.

Our Company C example also sheds some light on the effect of
the rate of interest on the apparent safety of the senior security.
If the $12,000,000 bond issue had carried a 6% coupon, the
interest charges of $720,000 would then be earned less than 1 Yt
times. Let us assume that Company D had such a bond issue.
An unwary investor, looking at the two exhibits, might reject
Company D’s 6% bonds as unsafe because their interest coverage
was only 1.39 but yet accept the Company C bonds at par
because he was satisfied with earnings of twice fixed charges.
Such discrimination would be scarcely intelligent. Our investor
would be rejecting a bond merely because it pays him a generous
coupon rate, and he would be accepting another bond merely
because it pays him a low interest rate. The real point, however,
is that the minimum margin of safety behind bond issues must
be set high enough to avoid the possibility that safety may even
appear to be achieved by a mere lowering of the interest rate.

546

SECURITY ANALYSIS

The same reasoning would apply of course to the dividend rate
on preferred stocks.

Since Company C bonds are not safe, because of the excessive
size of the issue, they are likely to sell at a considerable discount
from par. We cannot suggest the proper price level for such an
issue, but we have indicated in Chap. XXVI that a bond specula¬
tive because of inadequate safety should not ordinarily be
purchased above 70. It is also quite possible that the presence of
this excessive bond issue might prevent the stock from selling at
12 times its earnings, because conservative stock buyers would
avoid Company C as subject to too groat hazard of financial
difficulties in the event of untoward developments. The result
may well be that, instead of being worth $18,000,000 in the
market as originally assumed, the combined bond and stock
issues of Company C will sell for less than $15,000,000 (the
Company B valuation), or even for less than $12,000,000 (the
value of Company A).

As a matter of cold fact, it should be recognized that this
unfavorable result may not necessarily follow. If investors are
sufficiently careless and if speculators are sufficiently enthusias¬
tic, the securities of Company C may conceivably sell in the
market for $18,000,000 or even more. But such a situation
would be unwarranted and unsound. 1 Our theory of capitaliza¬
tion structure could not admit a Company C arrangement as in
any sense standard or suitable. This indicates that there are
definite limits upon the advantages to be gained by the use of
senior securities. We have already expressed this fact in our
principle of the optimum capitalization structure, for senior
securities cease to be an advantage at the point where their
amount becomes larger than can safely be issued or bought for
investment.

We have characterized the Company A type of capitalization
arrangement as “overconservative”; the Company C type may

1 In 1925 Dodge Brothers (motor) securities were sold to the public on
the basis of $160,000,000 principal value of bonds and preferred stock and
about $50,000,000 market value of common. Net tangible assets were only
$80,000,000, and average earnings about $16,000,000. This obviously
top-heavy capitalization structure did not militate against the security
values at first, but a severe decline in earnings in 1927 soon revealed the
unsoundness of the financial setup. (In 1928 the company was taken over
by Chrysler.)

ANALYSIS OF THE INCOME ACCOUNT

547

be termed “speculative,” whereas that of Company B may well
be called “suitable” or “appropriate.”

The Factor of Leverage in Speculative Capitalization Structure.

Although a speculative capitalization structure throws all the
company’s securities outside the pale of investment, it may give
the common stock a definite speculative advantage. A 25%
increase in the earnings of Company C (from $1,000,000 to
$1,250,000) will mean about a 50% increase in the earnings per
share of common (from $5.20 to $7.70). Because of this fact
there is some tendency for speculatively capitalized enterprises
to sell at relatively high values in the aggregate during good times
or good markets. Conversely, of course, they may be subject
to a greater degree of undervaluation in depression. There is,
however, a real advantage in the fact that such issues, when
selling on a deflated basis, can advance much further than they
can decline.

American W \ter Works and Electric Company

■■

Ratio of 1929

Item

1921

1923

1921

1929

figures to
1921 figures

Gross earnings*. .

$20,574

! !

$ 36,380

$ 38,35(') 1 '? 51,119

2 63

Net for charges* . .
Fixed charges and

0,692

12,GS4

13,770

22,770

3 44

preferred divi¬
dends*.

G, 353

11,315

12,780

16,151

2.54

Balance for common*
1021 basis; f

339

1,369

990

6,622

19.53

Number of shares

of common ....

92,000

100,000

130,000

1.41

Earned per share
High price of com¬

S3. OS

S13.69

$9.90

$51.00

13 86

mon.

6 V*

209

about 2500

385.00

7o earned on high

price of common

50.6%

30.6%

4.7%

2 04%

0.037

As reported:

Number of shares

of common

92,000

100,000

500,000

1,057,000

Earned per share
High price of com¬

S3.GS

$13.69

$1.98

$4.00

mon .

c H

44J£

41 %

199

* In thousands.

t Number of shares and price adjusted to eliminate effect of stock dividends and split-ups.

648

SECURITY ANALYSIS

The record of American Water Works and Electric Company
common stock between 1921 and 1929 presents an almost
fabulous picture of enhancement in value, a great part of which
was due to the influence of a highly speculative capitalization
structure. Four annual exhibits during this period are summar¬
ized in the table on page 547.

The purchaser of 1 share of American Water Works common
stock at the high price of 6^ in 1921, if he retained the distribu¬
tions made in stock, would have owned about 123 ^ shares when
the common sold at its high price of 199 in 1929. His $6.50
would have grown to about $2,500. While the market value of
the common shares was thus increasing some 400-fold, the gross
earnings had expanded to only 2.G times the earlier figure. The
tremendously disproportionate rise in the common-stock value
was due to the following elements, in order of importance:

1. A much higher valuation placed upon the per-share earnings
of this issue. In 1921 the company's capitalization was recog¬
nized as top-heavy; its bonds sold at a low price, and the earnings
per share of common were not taken seriously, especially since
no dividends were being paid on the second preferred. In 1929
the general enthusiasm for public-utility shares resulted in a
price for the common issue of nearly 50 times its highest recorded
earnings.

2. The speculative capitalization structure allowed the com¬
mon stock to gain an enormous advantage from the expansion
of the company's properties and earnings. Nearly all the
additional funds needed were raised by the sale of senior securi¬
ties. It will be observed that whereas the gross revenues
increased about 160% from 1921 to 1929, the balance per share
of old common stock grew 14-fold during the same period.

3. The margin of profit improved during these years, as shown
by the higher ratio of net to gross. The speculative capital
structure greatly accentuated the benefit to the common stock
from the additional net profits so derived. 1

Other Examples: The behavior of speculatively capitalized
enterprises under varying business conditions is well illustrated

1 See Appendix Note 59, p. 789, for data illustrating the reverse process
applied to American Water Works from 1929 through 1938; also for a
similar speculative opportunity in United Light and Power Company
Preferred Stock in 1935.

ANALYSIS OF THE INCOME ACCOUNT

549

by the appended analysis of A. E. Staley Manufacturing Com¬
pany, manufacturers of corn products. For comparison there is
given also a corresponding analysis of American Maize Products
Company, a conservatively capitalized enterprise in the same field.

The most striking aspect of the Staley exhibit is the extra¬
ordinary fluctuation in the yearly earnings per share of common
stock. The business itself is evidently subject to wide variations
in net profit, and the effect of these variations on the common
stock is immensely magnified by reason of the small amount of
common stock in comparison with the senior securities. 1 The
large depreciation allowance acts also as the equivalent of a

A. E. Staley

Year

Net before
deprecia¬
tion*

Deprecia¬

tion*

Fixed
charges
and pfd.
dividends*

Balance

for

common*

Earned
per share

1933

$2,563

$743

$652

$1,168

$55 63

1932

1,546

753

678

114

5.43

1931

892

696

692

496(d)

23.60(d)

1930

1,540

753

708

3 74

1929

3,266

743

757

1,766

84 09

1928

1,491

641

696

154

7 35

1927

1,303

531

541

231

11 01

1926

2,433

495

430

1,507

71.77

1925

792

452

358

lS(d)

0 87(d)

1921

1,339

419

439

481

22 89

* 000 omitted.

American Maize Products

Net before
Year deprecia¬
tion *

1933

1932

1931

1930

1929

1928

1927

Deprecia¬

tion*

Fixed
charges
and pfd.
dividends*

$301

299

306

312

317

105

318

105

Balance

for

common

Earned
per share

¥ 000 omitted.

1 In 1934 the company declared a 100 % stock dividend, thus doubling the
number of shares of common, and in 1937 split the stock 10 for 1 and
changed the par value from $100 to $10. These two developments multi-

550

SECURITY ANALYSIS

Capitalization (as op January 1933)

Item

A. E. Staley

American Maize
Products

6% bonds. .

($4,000,000* @ 75)

$7 pfd. stock.

S3,000,000
(50,000 sh. @ 44)

Common stock.

2,200,000
(21,000 sh. ® 45)

(300,000 sh. @ 20)

950,000

$6,000,000

Total capitalization.

$ 6,150,000

$6,000,000

Average earnings, 1927-1932,
about.

900,000

615,000

% of these earnings on 1933
capitalization.

14.6%

10.3%f

Average earnings per sh. of com¬
mon .

$14.76

$1 87

% earned on price of common..

32 8%

9 4 %f

Working capital, Dec. 31, 1932..

$ 3,664,000

$2,843,000

Net assets, Dec. 31, 1932.

$15,000,000

$1,827,000

* Deducting estimated amount of bonds m treasury.

t The difference between these two figures is due to the varying treatment of the preferred
stock outstanding during 1927-1930. A very small amount of prefen cd stock lemaimng
in 1931-1933 is ignored in the above calculations.

heavy fixed charge. Hence a decline in net before depreciation
from $3,266,000 in 1929 to $1,540,000 the next year, somewhat
over 50%, resulted in a drop in earnings per share of common
from $84 to only $3.74. The net profits of American Maize
Products were fully as variable, but the small amount of prior
charges made the fluctuations in common-stock earnings far
less spectacular.

Speculative Capitalization May Cause Valuation of Total
Enterprise at an Unduly Low Figure. —The market situation

plied the outstanding shares by 20. Persistence of the variable factor in
the earnings for the common stock is shown by the following per-share
figures, based on the 1933 capitalization:

1934

$28.46

1935

2.76(d)

1936

52.88

1937

18 40(d)

1938

38 80

1939

68.00

ANALYSIS OF THE INCOME ACCOUNT

551

of the Staley securities in January 1933 presents a practical
confirmation of our theoretical analysis of Company C above.
The top-heavy capitalization structure resulted in a low price for
the bonds and the preferred stock, the latter being affected
particularly by the temporary suspension of its dividend in 1931.
The result was that, instead of showing an increased total value
by reason of the presence of senior securities, the company sold in
the market at a much lower relative price than the conservatively
capitalized American Maize Products. (The latter company
showed a normal relationship between average earnings and
market value. It should not properly be termed overconserva -
tivcly capitalized because the variations in its annual earnings
would constitute a good reason for avoiding any substantial
amount of senior securities. A bond or preferred stock issue of
very small size, on the other hand, would be of no particular
advantage or disadvantage.)

The indication that the A. E. Staley Company was under¬
valued in January 1933 in comparison with American Maize
Products is strengthened by reference to the relative current-asset
positions and total resources. Per dollar of net asset values the
Staley company was selling only one-third as high as American
Maize.

The overdeflation of a speculative issue like Staley common in
unfavorable markets creates the possibility of an amazing price
advance when conditions improve, because the earnings per share
then show so violent an increase. Note that at the beginning of
1927 Staley common was quoted at about 75, and a year later it
sold close to 300. Similarly the shares advanced from a low of 33
in 1932 to the equivalent of 320 in 1939.

A Corresponding Example .—A more spectacular instance of
tremendous price changes for the same reason is supplied by
Mohawk Rubber. In 1927 the common sold at 15, representing
a valuation of only $300,000 for the junior issue, which followed
$1,960,000 of preferred. The company had lost $610,000 in
1926 on $6,400,000 of sales. In 1927 sales dropped to $5,700,000,
but there was a net profit of $630,000. This amounted to over
$23 per share on the small amount of common stock. The price
consequently advanced from its low of 15 in 1927 to a high of
251 in 1928. In 1930 the company again lost $669,000, and the
next year the price declined to the equivalent of only $4.

552

SECURITY ANALYSIS

In a speculatively capitalized enterprise, the common stock¬
holders benefit—or have the possibility of benefiting—at the
expense of the senior security holders. The common stockholder
is operating with a little of his own money and with a great deal
of the senior security holder’s money; as between him and them
it is a case of “ Heads I win, tails you lose.” This strategic posi¬
tion of the common stockholder with relatively small commitment
is an extreme form of what is called “ trading on the equity.”
Using another expression, he may be said to have a “cheap call”
on the future profits of the enterprise.

Speculative Attractiveness of “Shoe-string” Common Stocks
Considered.—Our discussion of fixed-value investment has
emphasized as strongly as possible the disadvantage (amounting
to unfairness) that attaches to the senior security holder’s
position where the junior capital is proportionately slight. The
question would logically arise if there are not corresponding
advantages to the common stock in such an arrangement, from
which it gains a very high degree of speculative attractiveness.
This inquiry would obviously take us entirely outside the field
of common-stock investment but would represent an expedition
into the realm of intelligent or even scientific speculation.

We have already seen from our A. E. Staley example that in
bad times a speculative capitalization structure may react
adversely on the market price of both the senior securities and
the common stock. During such a period, then, the common
stockholders do not derive a present benefit at the expense of
the bondholder. This fact clearly detracts from the speculative
advantage inherent in such common stocks. It is easy to suggest
that these issues be purchased only when they are selling at
abnormally low levels due to temporarily unfavorable conditions.
But this is really begging the question, because it assumes that
the intelligent speculator can consistently detect and wait for
these abnormal and temporary conditions. If this were so, he
could make a great deal of money regardless of what type of
common stock he buys, and under such conditions he might be
better advised to select high-grade common stocks at bargain
prices rather than these more speculative issues.

Practical Aspects of the Foregoing .—To view the matter in a
practical light, the purchase of speculatively capitalized common
stocks must be considered under general or market conditions

ANALYSIS OF TEE INCOME ACCOUNT

553

that are supposedly normal, i.e., under those which are not
obviously inflated or deflated. Assuming (1) diversification,
and (2) reasonably good judgment in selecting companies with
satisfactory prospects, it would seem that the speculator should
be able to profit rather substantially in the long run from commit¬
ments of this kind. In making such purchases, partiality should
evidently be shown to those companies in which most of the
senior capital is in the form of preferred stock rather than bonds.
Such an arrangement removes or minimizes the danger of extinc¬
tion of the junior equity through default in bad times and thus
permits the shoe-string common stockholder to maintain his
position until prosperity returns. (But just because the pre¬
ferred-stock contract benefits the common share-holder in this
way, it is clearly disadvantageous to the preferred stockholder
himself.)

We must not forget, however, the peculiar practical difficulty
in the way of realizing the full amount of prospective gain in
any one of the purchases. As we pointed out in the analogous
case of convertible bonds, as soon as a substantial profit appears
the holder is in a dilemma, because he can hold for a further gain
only by risking that already accrued. Just as a convertible bond
loses its distinctive advantages when the price rises to a point
that carries it clearly outside of the straight investment class,
so a shoe-string common-stock commitment is transformed into a
more and more substantial commitment as the price continues
to rise. In our Mohawk Rubber example the intelligent pur¬
chaser at 15 could not have expected to hold it beyond 100—even
though its quotation did reach 250—because at 100, or before,
the shares had lost the distinctive characteristics of a specula¬
tively capitalized junior issue.

CHAPTER XLI

LOW-PRICED COMMON STOCKS. ANALYSIS OF
THE SOURCE OF INCOME

LOW-PRICED STOCKS

The characteristics discussed in the preceding chapter are
generally thought of by the public in connection with low-priced
stocks . The majority of issues of the speculatively capitalized
type do sell within the low-priced range. The definition of “low-
priced” must, of course, be somewhat arbitary. Prices below
$10 per share belong to this category beyond question; those
above $20 are ordinarily excluded; so that the dividing line would
be set somewhere between $10 and $20.

Arithmetical Advantage of Low-priced Issues. —Low-priced
common stocks appear to possess an inherent arithmetical
advantage arising from the fact they can advance so much more
than they can decline. It is a commonplace of the securities
market that an issue will rise more readily from 10 to 40 than from
100 to 400. This fact is due in part to the preferences of the
speculative public, which generally is much more partial to issues
in the 10-to-40 range than to those selling above 100. But it is
also true that in many cases low-price common stocks give the
owner the advantage of an interest in, or “call” upon, a relatively
large enterprise at relatively small expense.

A statistical study of the relative price behavior of industrial
stocks in various price groups was presented in the April 1936
issue of The Journal of Business of the University of Chicago .*
The study was devoted to the period 1926-1935 2 and revealed a
continuous superiority of diversified, low-priced issues over

1 Fritzemeier, Louis H., “ Relative Price Fluctuations of Industrial
Stocks in Different Price Groups,” loc. cit pp. 133-154.

2 See pp. 473-474 of the 1934 edition of this work for reference to an
earlier study devoted to the relative behavior of low-priced and high-
priced issues when purchased at or near the bottoms of depressions in 1897,
1907, 1914 and 1921. Within its more limited scope this study, published

554

ANALYSIS OF THE INCOME ACCOUNT

555

diversified, high-priced issues as speculative media. The follow¬
ing quotation from the study summarizes the results and con¬
clusions reached by the author:

Unless there are serious uncompensated errors in the statistical work
here presented, this investigation would seem to establish the existence
of certain relationships between price level and price fluctuations which
have hitherto gone unreported by students of stock-market phenomena.
These relationships may be briefly stated as follows:

1. Low-price stocks tend to fluctuate relatively more than high-price
stocks.

2. In a "bull” market the low-price stocks tend to go up relatively
more than high-price stocks, and they do not lose these superior gains
in the recessions which follow. In other words, the downward move¬
ment of low-price stocks is less than proportional to their upward move¬
ment, when compared with the upward and downward movement of
high-price stocks.

Assuming (1) that the future behavior of the various price groups will
be similar to their past behavior and (2) that the selection of stocks on
the basis of the activity for the current year does not account completely,
if at all, for the superior performance of the stocks in the low-price
groups, it seems logical to conclude the following:

1. Low-price industrial stocks offer greater opportunities for specu¬
lative profits than high-price industrial stocks.

2. In case two or more issues of industrial stocks seem to offer equal
prospective profits, the speculator should purchase the shares selling at
the lowest price.

Some Reasons Why Most Buyers of Low-priced Issues Lose
Money.—The pronounced liking of the public for “cheap stocks”
would therefore seem to have a sound basis in logic. Yet it is
undoubtedly true that most people who buy low-priced stocks
lose money on their purchases. Why is this so? The underlying
reason is that the public buys issues that are sold to it, and the
sales effort is put forward to benefit the seller and not the buyer.
In consequence the bulk of the low-priced purchases made by
the public are of the wrong kind; z.e., they do not provide the
real advantages of this security type. The reason may be either
because the companies are in bad financial condition or because

in 1931 by J. H. Holmes and Company, led to conclusions similar to those
of Fritzemeier.

556

SECURITY ANALYSIS

the common stock is low-priced in appearance only and actually
represents a full or excessive commitment in relation to the size
of the enterprise. The latter is preponderantly true of new
security offerings in the low-priced range. In such cases, a
pseudo-low price is accomplished by the simple artifice of creating
so large a number of shares that even at a few dollars per share the
total value of the common issue is excessive. This has been true
of mining-stock flotations from of old and was encountered again
in the liquor-stock offerings of 1933 and in the airplane issues in
1938-1939.

A genuinely low-priced common stock will show an aggregate
value for the issue which is small in relation to the company's
assets, sales and past or prospective profits. The examples
shown herewith will illustrate the difference between a“genuine”
and “pseudo-low” price.

Item

Wright-
Hargreaves
Mines, Ltd.
(gold mining)

Barker

Bros. Corp.
(retail store)

July 1933:

Price of common stock.

Number of shares outstanding

5,500,000

148,500

Total value of common.

$38,500,000

$ 743,000

Preferred stock at par.

2,815,000

500,000

Preferred stock at market. ...

Year 1932:

Sales.

3 3,983,000

8,154,000

Net earnings.

2,001,000*

703,000{d)

Period 1924-1932:

Maximum sales.

3 3,983,000

$16,261,000

Maximum net earnings.

2,001,000*

1,100,000

Maximum earnings per share

of common.

0.36*

$7.59

Working capital, Dec. 1932...

$ 1,930,000

$ 5,010,000

Net tangible assets, Dec. 1932

4,644,000

7,200,000

* Before depletion.

The Wright-Hargreaves issue was low-priced in appearance
only, for in fact the price registered a very high valuation for
the company as compared with all parts of its financial exhibit.
The opposite was true of Barker Brothers because here the $743,-

ANALYSIS OF THE INCOME ACCOUNT

557

000 valuation represented by the common stock was exceedingly
small in relation to the size of the enterprise. (Note also that
the same statement could be applied to Barker Brothers Pre¬
ferred, which at its quotation of *18 partook of the qualities of a
low-priced common stock.) 1

Observation of the stock market will show that the stocks
of companies facing receivership are likely to be more active
than those which are very low in price merely because of poor
current earnings. This phenomenon is caused by the desire of
insiders to dispose of their holdings before the receivership wipes
them out, thus accounting for a large supply of these shares at a
low level and also sometimes for unscrupulous efforts to persuade
the unwary public to buy them. But where a low-priced stock
fulfills our conditions of speculative attractiveness, there is apt
to be no pressure to sell and no effort to create buying. Hence
the issue is inactive and attracts little public attention. This
analysis may explain why the public almost always buys the
wrong low-priced issues and ignores the really promising oppor¬
tunities in this field.

Low Price Coupled with Speculative Capitalization.—Specula¬
tively capitalized enterprises, according to our definition, are
marked by a relatively large amount of senior securities and a
comparatively small issue of common stock. Although in most
cases the common stock will sell at a low price per share, it need
not necessarily do so if the number of shares is small. In the
Staley case, for example (referred to on page 550) even at $50
per share for the common in 1933 the capitalization structure
would still have been speculative, since the bonds and preferred at
par would represent over 90% of the total. It is also true that
even where there are no senior securities the common stock may
have possibilities equivalent to those in a speculatively capital¬
ized enterprise. These possibilities will occur wherever the
market value of the common issue represents a small amount of

1 See Appendix Note 60, p. 790, for the sequel to these examples. For a
more recent contrast along the same lines the student is invited to compare
the showing of Continental Motors Corporation and Gilchrist Company
when both were selling at $5 near the close of 1939. Beyond our basic
distinction, founded on the relationship between the valuation of the
company and its assets and sales, there is here a striking contrast in the
earnings record and working-capital position.

558

SECURITY ANALYSIS

money in relation to the size of the business, regardless of how it
is capitalized.

To illustrate this point we append a condensed analysis of
Mandel Brothers, Inc., and Gimbel Brothers, Inc., two depart¬
ment-store enterprises, as of September 1939.

Item

Gimbel Bros.

Mandel Bros.

September 1939:

Bonds at par.

Preferred stock.

$ 26,753,000
197,000 sh. @ 50
$ 9,850,000

Common stock.

977,000 sh. @ 8
$ 7,816,000

297,000 S h. @5

S 1,485,000

Total capitalization.

Results for 12 months to July 31,
1939:

$ 44,419,000

$ 1,485,000

Sales.

$ 87,963,000

$ 17,883,000

Net before interest.

1,073

155,000

Balance for common.

1,105(d)

155,000

Earned per share.

Period 1934-1938*:

1.13(d)

0.52

Maximum sales (1937).

Maximum net earnings (1937)

$100,081,000

$19,378,000

for common.

Maximum earnings per share

2,032,000

414,000

of common (1937).

2.08

1.33

High price of common.

Average earnings per share of

29 % (1937)

18 (1936)

common.

Jan. 31, 1939:

0 23

0.46

Net current assets.

$ 22,916,000

$ 4,043,000

Net tangible assets.

75,614,000

6,001,000

Rents paid 1937.

1,401,000

867,000

* Based on report for succeeding Jan. 31.

Gimbel Brothers presents a typical picture of a speculatively
capitalized enterprise. On the other hand Mandel Brothers has
no senior securities ahead of the common, but despite this fact
the relatively small market value of the entire issue imparts to
the shares the same sort of speculative possibilities (though in
somewhat lesser degree) as are found in the Gimbel Brothers
set-up. Note, however, that the rental payments of Mandel
Brothers are proportionately much higher than those of Gimbel

ANALYSIS OF THE INCOME ACCOUNT

559

Brothers and that these rental charges are equivalent in good
part to senior securities.

Large Volume and High Production Cost Equivalent to
Speculative Capital Structure. —This example should lead us to
widen our conception of a speculatively situated common stock.
The speculative or marginal position may arise from any cause
that reduces the percentage of gross available for the common
to a subnormal figure and that therefore serves to create a
subnormal value for the common stock in relation to the volume
of business. Unusually high operating or production costs have
the identical effect as excessive senior charges in cutting down
the percentage of gross available for common. The following
hypothetical examples of three copper producers will make this
point more intelligible and also lead to some conclusions on the
subject of large output versus low operating costs.

Item

| Company A

Company B

Company C

Capitalization:

6% Bonds.

$50,000,000
1,000,000 sh.

Common stock.

1,000,000 sh.

Output.

Cost of production (before

100,000,000 lb.

150,000,000 lb.

interest).

Interest charge per pound

■H

Total cost per pound.

* — N

Assumed price of copper.

10f!

lOff

Profit per pound.

Output per share.

100 lb.

1501b.

Profit per share.

Value of stock at 10 times

$ 1.50

earnings.

Output per $1 of market

$30

$15

value of stock.

3 H lb.

10 lb.

Assumed price of copper.

13^

131

Profit per pound.

Profit per share.

Value per share at ten

$ 6

% 6

times earnings.

Output per $1 of market

$60

price of stock.

1% lb.

2M lb.

It is scarcely necessary to point out that the higher production
cost of Company C will have exactly the same effect as the bond-

560

SECURITY ANALYSIS

interest requirement of Company B (assuming output and pro¬
duction costs to continue as stated).

General Principle Derived .—The foregoing table is perhaps more
useful in showing concretely the inverse relationship that usually
exists between profit per unit and output per dollar of stock value.

The general principle may be stated that the lower the unit
cost the lower the production per dollar of market value of stock
and vice versa . Since Company A has a 7-cent cost, its stock
naturally sells at a higher price per pound of output than Company
C with its 9-cent cost. Conversely, Company C produces more
pounds per dollar of stock value than Company A . This fact is
not without significance from the standpoint of speculative
technique. When a rise in the price of the commodity occurs,
there will ordinarily be a larger advance, percentagewise, in the
shares of high-cost producers than in the shares of low-cost
producers. The foregoing table indicates that a rise in the price
of copper from 10 to 13 cents would increase the value of Com¬
pany A shares by 100% and the value of Company B and C shares
by 300%. Contrary to the general impression in Wall Street,
the stocks of high-cost producers are more logical commitments
than those of the low-cost producers when the buyer is convinced
that a rise in the price of the product is imminent and he wishes
to exploit this conviction to the utmost. 1 Exactly the same
advantage attaches to the purchase of speculatively capitalized
common stocks when a pronounced improvement in sales and
profits is confidently anticipated.

THE SOURCES OF INCOME

The “source of income” will ordinarily be thought of as
meaning the same thing as the “type of business.” This con¬
sideration enters very largely into the basis on which the public
will value the earnings per share shown by a given common stock.
Different “multipliers” are used for different sorts of enterprise,

1 The action of the market in advancing Company B shares from 15 to
60 because copper rises from 10 to 13 cents is in itself extremely illogical,
for there is ordinarily no warrant for supposing that the higher metal price
will be permanent . However, since the market does in fact behave in this
irrational fashion, the speculator must recognize this behavior in his
calculation.

ANALYSIS OF THE INCOME ACCOUNT

661

but we must point out that these distinctions are themselves
subject to change with the changing times. 1 Prior to the World
War the railroad stocks were valued most generously of all,
because of their supposed stability. In 1927-1929 the public-
utility group sold at the highest ratio to earnings, because of their
record of steady growth. Between 1933 and 1939 adverse
legislation and, in particular, the fear of government competition
greatly reduced the relative popularity of the utility stocks.
The most liberal valuations have recently been accorded to the
large and well-entrenched industrial enterprises which were able
to maintain substantial earnings during the depression and are
considered to possess favorable long-term prospects. Because
of these repeated variations in relative behavior and popularity,
security analysis must hesitate to prescribe any definitive rules
for valuing one type of business as against another. It is a
truism to say that the more impressive the record and the more
promising the prospects of stability and growth the more liberally
the per-share earnings should be valued, subject always to our
principle that a multiplier higher than about 20 (i.e., an “earnings
basis ” of less than 5%) will carry the issue out of the investment
price range.

A Special Phase: Three Examples. —A more fruitful field for
the technique of analysis is found in those cases where the source
of income must be studied in relation to specific assets owned by
the company, instead of in relation merely to the general nature
of the business. This point may be quite important when a
substantial portion of the income accrues from investment
holdings or from some other fixed and dependable source. Three
examples will be used to illuminate this rather subtle aspect of
common-stock analysis.

1. Northern Pipe Line Company .—For the years 1923-1925 the
Northern Pipe Line Company reported earnings and dividends
as follows:

1 Sec Cowles, Alfred, 3d, and associates (Common Stock Indexes, 1871—
1937), pp. 43-46, 404-418, Bloomington, Ind., 1938, for a study of earnings-
price ratios for different industrial groups in successive years from 1871
through 1937. Ratios for 1934-1938 and for 1936-1938 are supplied in our
analysis of the New York Stock Exchange industrial list in Appendix Note
61, p. 790.

562

SECURITY ANALYSIS

Year

Net earnings

Earned per share*

Dividend paid

1923

$308,000

$7.70

$10, plus $15 extra

1924

214,000

5.35

1925

311,000

7.77

* Capitalisation, 40,000 shares of common stock.

In 1924 the shares sold as low as 72, in 1925 as low as 673^
and in 1926 as low as 64. These prices were on the whole some¬
what less then ten times the reported earnings and reflected a
lack of enthusiasm for the shares, due to a pronounced decline in
profits from the figures of preceding years and also to the reduc¬
tions in the dividend.

Analysis of the income account however, would have revealed
the following division of the sources of income: 1

Income

1924

1925

Per share

Total

Per share

Total

Per share

Earned from:

Pipe-line operations
Interest and rents..
Nonrecurrent items

$179,000
104,000
dr. 35,000

$4.48
4.10
dr. 0.88

$ 69,000
159,000
dr. 14,000

$1.71

3.99

0.35

$103,000
170,000
cr. 38,000

$2.57
4.25
cr. 0.95

$308,000

$7.70

$214,000

$5.35

$311,000

$7.77

This income account is exceptional in that the greater part of
the profits were derived from sources other than the pipe-line
business itself. About $4 per share were regularly received in
interest on investments and rentals. The balance sheet showed
holdings of nearly $3,200,000 (or $80 per share) in Liberty Bonds
and other gilt-edged marketable securities, on which the interest
income was about 4%.

This fact meant that a special basis of valuation must be
applied to the per-share earnings, inasmuch as the usual “ten-
times-eamings ,, basis would result in a nonsensical conclusion.

1 Although the company's reports to its stockholders contained very little
information, complete financial and operating data were on file with the
Interstate Commerce Commission and open to public inspection.

ANALYSIS OF THE INCOME ACCOUNT

563

Gilt-edged investments of $80 per share would yield an income
of $3.20 per share, and at ten times earnings this $80 would be
“worth” only $32 per share, a reductio ad absurdum. Obviously,
that part of the Northern Pipe Line income that was derived
from its bond holdings should logically be valued at a higher basis
than the portion derived from the fluctuating pipe-line business.
A sound valuation of Northern Pipe Line stock would therefore
have to proceed along the lines suggested below. The pipe-line
earnings would have to be valued at a low basis because of their
unsatisfactory trend. The interest and rental income must
presumably be valued on a basis corresponding with the actual

Average 1923-1925*

Valuation basis

Value
per share

Earned per share from pipe line. $2.92

15 % (6 % times earnings)

$ 20

Earned per share from interest

and rentals. 4.10

5% (20 times earnings)

Total. $7.02

$100

* The nonrecurrent profits and losses are not taken into account.

value of the assets producing the income. This analysis indi¬
cated clearly that, at the price of 64 in 1926, Northern Pipe Line
stock was selling considerably below its intrinsic value. 1

2. Lackawanna Securities Company .—This company was
organized to hold a large block of Glen Alden Coal Company 4%
bonds formerly owned by the Delaware, Lackawanna and Western
Railroad Company, and its shares were distributed pro rata to
the Delaware, Lackawanna and Western stockholders. The
Securities Company had outstanding 844,000 shares of common
stock. On December 31, 1931 its sole asset—other than about
$1 per share in cash—consisted of $51,000,000 face value of
Glen Alden 4% first mortgage bonds. For the year 1931, the
income account was as follows:

1 A parallel situation existed in the case of Davis Coal and Coke Company
prior to the distribution of $50 per share to stockholders out of its large
holdings of government bonds in 1937-1938. Shortly prior to this action
the stock had sold at 35. The student can see from the annual reports that
the average earnings of $2.06 per share and average dividends of $2.56 in
1934-1937 came entirely from sources other than the coal business.

564

SECURITY ANALYSIS

Interest received on Glen Alden bonds. $2,084,000

Less:

Expenses... 17,000

Federal taxes. 250,000

Balance for stock. 1,817,000

Earned per share. $2.15

Superficially, the price of 23 in 1932 for a stock earning $2.15
did not appear out of line. But these earnings were derived,
not from ordinary commercial or manufacturing operations, but
from the holding of a bond issue which presumably constituted
a high-grade investment. (In 1931 the Glen Alden Coal Com¬
pany earned $9,550,000 available for interest charges of $2,151,-
000, thus covering the bond requirements 4 Yi times.) By valuing
this interest income on about a 10% basis the market was in
fact valuing the Glen Alden bonds at only 37 cents on the dollar
(The price of 23 for a share of Lackawanna Securities was equiva¬
lent to $60 face value of Glen Alden bonds at 37, plus $1 in cash)
Here again, as in the Northern Pipe Line example, analysis
would show convincingly that the customary tcn-times-earnings
basis resulted in a glaring undervaluation of this specially situated
issue.

Tobacco Products Corporation

Item

Price:
December
1931

Market value

Capitalization

2,240,000 shares of 7 % Class A

(par $20).

$13,440,000

3,300,000 shares common.

2 X

7,425,000

Total.

$20,825,000

Net income for the year 1931..

....

about $ 2,200,000

Earned per share of Class A ...

....

about $1

Earned for common after Class

A dividends.

....

nil

Dividend paid on Class A .

$0.80

3. Tobacco Products Corporation of Virginia .—In this example,
as in the other two, the company was selling in the market for
about ten times the latest reported earnings. But the 1931
earnings of Tobacco Products were derived entirely from a

ANALYSIS OF THE INCOME ACCOUNT

565

lease of certain of its assets to American Tobacco Company,
which provided for an annual rental of $2,500,000 for 99 years
from 1923. Since the American Tobacco Company was able
to meet its obligation without- question, this annual rental
income was equivalent to interest on a high-grade investment.
Its value was therefore much more than ten times the income
therefrom. This meant that the market valuation of the
Tobacco Products stock issues in December 1931 was far less than
was justified by the actual position of the company. (The value
of the lease was in fact calculated to be about $35,600,000 on
an amortized basis. The company also owned a large amount
of United Cigar Stores’ stock, which later proved to be prac¬
tically worthless, but these additional holdings did not, of course,
detract from the value of its American Tobacco lease.)

Relative Importance of Situations of This Kind—The field
of study represented by the foregoing examples is not important
quantitatively, because, after all, only a very small percentage
of the companies examined will fall within this group. Situa¬
tions of this kind arise with sufficient frequency, however, to
give this discussion practical value. It should be useful also in
illustrating again the wide technical difference between the
critical approach of security analysis and the highly superficial
reactions and valuations of the stock market.

Two Lines of Conduct Suggested.—When it can be shown
that certain conditions, such as those last discussed, tend to give
rise to undervaluations in the market, two different lines of
conduct are thereby suggested. We have first an opportunity
for the securities analyst to detect these undervaluations and
eventually to profit from them. But there is also the indication
that the financial set-up that causes this undervaluation is
erroneous and that the stockholders’ interests require the cor¬
rection of this error. The very fact that a company consti¬
tuted like Northern Pipe Line or Lackawanna Securities tends
to sell in the market far below its true value proves as strongly
as possible that the whole arrangement is wrong from the stand¬
point of the owners of the business.

At the bottom of these cases there is a basic principle of
consistency involved. It is inconsistent for most of the capital
of a pipe-line enterprise actually to be employed in the ownership
of gilt-edged bonds. The whole set-up of Lackawanna Securities

566

SECURITY ANALYSIS

was also inconsistent, because it replaced a presumably high-
grade bond issue, which investors might be willing to buy at a
fair price, by a nondescript stock issue which no one would
purchase except at an exceptionally low price. (In addition a
heavy and needless burden of corporate income tax was involved,
as was true in the Tobacco Products case.)

Illogical arrangements of this kind should be recognized by
the real parties in interest, i,e., the stockholders, and they should
insist that the anomaly be rectified. This was finally done in
the three examples just given. In the case of Northern Pipe
Line the capital not needed in the pipe-line business was returned
to the stockholders by means of special distributions aggregating
$70 per share. The Lackawanna Securities Company was
entirely dissolved and the Glen Alden bonds in its treasury
distributed pro rata to the stockholders in lieu of their stock.
Finally, the Tobacco Products Corporation was recapitalized
on a basis by which 63^ % bonds were issued against the American
Tobacco lease, so that this asset of fixed value was represented
by a fixed-value security (which later were redeemed at par)
instead of by shares of stock in a corporation subject to highly
speculative influences. By means of these corporate rearrange¬
ments the real values were speedily established in the market
price. 1

The situations that we have just analyzed required a transfer
of attention from the income account figures to certain related
features revealed in the balance sheet. Hence the foregoing
topic—Sources of Income—carries us over into our next field of
inquiry: The Balance Sheet.

1 The student is invited to consider two further examples illustrating this
point in 1939, viz.

1. Westmoreland Coal Company, selling at 8 although the company
held some $18 per share in cash assets alone. This case is broadly similar
to our Davis Coal and Coke example, although there were some differences.
See discussion of this company on pp. 608-609.

2. American Cigarette and Cigar. In this case there is also a long-term
lease to American Tobacco Company (as in the Tobacco Products example),
but the situation is complicated by the company's own operations, which
have produced losses, and by ownership of other assets.

Attention is drawn also to our discussion of Lehigh Coal and Navigation
Company on pp. 443-444, in which we suggested that the mining losses were
perhaps inseparable from the large income from lease of the railroad.

PART VI

BALANCE-SHEET ANALYSIS. IMPLICATIONS OF
ASSET VALUES

CHAPTER XLII

BALANCE-SHEET ANALYSIS: SIGNIFICANCE OF
BOOK VALUE

On numerous occasions prior to this point we have expressed
our conviction that the balance sheet deserves more attention
than Wall Street has been willing to accord it for many years
past. By way of introduction to this section of our work, let us
list five types of information and guidance that the investor may
derive from a study of the balance sheet:

1. It shows how much capital is invested in the business.

2. It reveals the ease or stringency of the company’s financial condition,
i.e. } the working-capital position.

3. It contains the details of the capitalization structure.

4. It provides an important check upon the validity of the reported
earnings.

5. It supplies the basis for analyzing the sources of income.

In dealing with the first of these functions of the balance sheet,
we shall begin by presenting certain definitions. The book
value of a stock is the value of the assets applicable thereto
as shown in the balance sheet. It is customary to restrict this
value to the tangible assets, i.e., to eliminate from the calculation
such items as good-will, trade names, patents, franchises, lease¬
holds. The book value is also referred to as the “asset value,”
and sometimes as the “tangible-asset value,” to make clear
that intangibles are not included. In the case of common stocks,
it is also frequently termed the “ equity.”

Computation of Book Value.—The book value per share of a
common stock is found by adding up all the tangible assets,

567

568

SECURITY ANALYSIS

subtracting all liabilities and stock issues ahead of the common
and then dividing by the number of shares.

In many cases the following formula will be found to furnish a
short cut to the answer:

Book Value per share of common

Common Stock + Surplus Items — Intangibles
Number of shares outstanding

By Surplus Items are meant not only items clearly marked as
surplus but also premiums on capital stock and such reserves
as are really part of the surplus. This would include, for
example, reserves for preferred-stock retirement, for plant
improvement, and for contingencies (unless known to be actually
needed). Reserves of this character may be termed “ Volun¬
tary Reserves.”

Calculation of Book Value of United States Steel Common on
December 31, 1938

Condensed Balance Sheet December 31, 1938
(In millions)

Assets

Liabilities

Property Investment Ac-

Common Stock. $

653

count (less deprccia-

Preferred Stock.

360

tion). $1,

166

Subsidiary Stocks Pub-

Mining Royalties.

licly Held.

Deferred Charges 1 .

10.

Bonded Debt.

232

Miscellaneous Invest-

11.

Mining Royalty Notes.

ments.

12.

Current Liabilities.

Miscellaneous Other As-

13.

Contingency and Other

sets.

Reserves.

6. Current Assets .

510

.14.

Insurance Reserves.

15.

Capital Surplus.

16.

Earned Surplus.

247

$1,711

Tangible assets.

. $1,711,000,000

Less: All liabilities ahead of common

(Sum of items 8-12)

. 688,000,000

Net assets for common stock .

. $1,023,000,000

Book value per share (on 8,700,000 shares) $117.59

1 Considerable argument could be staged over the question whether Deferred Charges are
intangible or tangible assets, but as the amount involved is almost always small, the matter
has no practical importance. It is more convenient, of course, to include the Deferred
Charges with the other assets.

The alternative method of computation, which is usually
shorter than the foregoing, is as follows:

BALANCE-SHEET ANALYSIS

669

Common stock. $ 653,000,000

Surplus and voluntary reserves

(Sum of items 13-16). 370,000,000

Net assets for common stock. $1,023,000,000

Treatment of Preferred Stock When Calculating Book Value
of Common. —In calculating the assets available for the common
stock, care must be taken to subtract preferred stock at its proper
valuation. Ordinarily, this will be the par or stated value of the
preferred stock as it appears in the balance sheet. But there is
a growing number of cases in which pi of erred stock is carried
in the balance sheet at arbitrary values far lower than the real
liability attaching thereto.

Island Creek Coal Company has a preferred stock of $1 par,
which is entitled to annual dividends of $6 and to $120 per
share in the event of dissolution. In 1939 the price of this
issue ruled about 120. In the calculation of the asset value of
Island Creek Coal Common the preferred stock should be
deducted not at $1 per share but at $100 per share, its “true”
or “effective” par, or else at 120. Capital Administration Com¬
pany, Ltd., an investment trust, has outstanding preferred stock
entitled to $3 cumulative dividends and to $50 or $55 in liqui¬
dation, but its par value is $10. It has also a Class A stock
entitled to $20 in liquidation plus 70% of the assets remaining
and to 70% of the earnings paid out after preferred dividends,
but the par value of this issue is $1. Finally it has Class B
stock, par 1 cent, entitled to the residue of earnings and assets.
Obviously a balance sheet set up on the basis of par value is worse
than meaningless in this case, and it must be corrected by the
analyst somewhat as follows:

Balance Sheet December 31, 1938

As published

As revised

Total assets (at cost).

$5,335,300

1,661,200

434,000

143,400

2,400

3,094,300

(at rakt.) $5,862,500
1,661,200
(at 55*) 2,387,000

(at 20*) 2,868,000

1,048,600(d)

Payables and accruals.

Preferred stock (at par $10).

Class A stock (at par $1).

Common stock (at par 1 cent).

Surplus and reserves.

Total liabilities.

$5,335,300

$5,862,600

* Those approximate the effective par values of the issues.

670

SECURITY ANALYSIS

Coca-Cola Company has outstanding a no-par Class A stock
entitled to preferential dividends of $3 per share, cumulative, and
redeemable at 55. The company carries this issue as a liability
at its “stated value” of $5 per share. But the true par value is
clearly $50. 1

In all instances such as the above an “effective par value”
must be set up for the preferred stock that will correspond
properly to its dividend rate. A strong argument may be
advanced in favor of valuing all preferred stocks on a uniform
dividend basis, say 5%, unless callable at a lower figure. This
would mean that a $1,000,000 five per cent issue would be valued
at $1,000,000, a $1,000,000 four per cent issue would be given an
effective value of $800,000 and a $1,000,000 seven per cent non-
callable issue would be given an effective value of $1,400,000.
But it is more convenient, of course, to use the par value, and in
most cases the result will be sufficiently accurate. 2 A simpler
method, which would work well for most practical purposes, is
to value preferred issues at par (plus back dividends) or market,
whichever is higher.

Calculation of Book Value of Preferred Stocks.—In calculating
the book value of a preferred stock issue it is treated as a common
stock and the issues junior to it are left out of consideration.
The following computations from the December 31,1932, balance

1 Amusingly enough, in 1929 the company carried as an asset 194,000
repurchased shares of Class A stock at their cost of 89,434,000, although
the entire issue of 1,000,000 shares appeared as a liability of only $5,000,000.
For a similar accounting absurdity applied to common stocks, sec the June
1939 balance sheet of Hecker Products—on which its net stated liability
for its capital stock works out as a minus figure.

1 Standard Statistics Company, Inc., follows the practice of deducting
preferred stock at its value in case of involuntary liquidation , when computing
the book value of the common. This is scarcely logical, because dissolution
or liquidation is almost always a remote contingency and would take place
under conditions quite different from those obtaining at the time of analysis.
The Standard Statistics Company method results in placing a “value''
of $115 per share on Procter and Gamble Company $5 Second Preferred
and a value of only $100 per share on the same company's $8 First Preferred.
The real or practical value of the preferred stockholder's claims in this case
would be much nearer in the proportion of 160 for the First Preferred against
100 for the Second Preferred, a 5 % dividend yield basis for both. In the
case of investment-trust issues, liquidation values of preferred issues are
more relevant and should generally be used.

BALANCE-SHEET ANALYSIS 571

sheet of Tubize Chatillon Corporation will illustrate the principles
involved.

Tubize Chatillon Corporation
Balance Sheet December 31, 1932
Assets Liabilities

Property and Equip¬

ment. $19,009,000

Patents, Processes, etc. 802,000

Miscellaneous Assets.. 478,000

Current Assets. 4,258,000

Total assets. $24,547,000

7 % First Preferred
Stock (par $100)... $ 2,500,000
$7 Second Preferred

Stock (par $1). 136,000

Common Stock (par

$1). 294,000

Bonded Debt. 2,000,000

Current Liabilities.... 613,000

Reserve for Deprecia¬
tion, etc. 11,456,000

Surplus. 7,548,000

Total liabilities... $24,547,000

The book value of the First Preferred is computed as follows:

Total Assets.

Less: Intangible Assets.

Reserve for Depreciation, etc

Bonds.

Current Liabilities.

Net assets for First Preferred.

Book value per share.

. $24,547,000

802,000

11,456,000

2,000,000

613,000 14,871,000

. $ 9,676,000

. $387

Alternative method:

Capital Stock at par. $ 2,930,000

Surplus. 7,548,000

$10,478,000

Less Intangible Assets. 802,000

Net assets for First Preferred. $ 9,676,000

The Reserve for Depreciation and Miscellaneous Purposes was
very large and might have included arbitrary allowances belong¬
ing in Surplus. But in the absence of details a reserve of this
kind must be deducted from the assets. (It later transpired that
a substantial part of the reserve was needed to absorb a write-off
of plant abandoned owing to obsolescence.)

The book value of the Second Preferred stock is readily com¬
puted from the foregoing, as follows:

572

SECURITY ANALYSIS

Net assets for First Preferred. $9,676,000

Less: First Preferred at par. 2,500,000

Net assets for Second Preferred. $7,176,000

Book value per share. $52.75

In computing the book value of the common it would be an
obvious error to deduct the Second Preferred at its nonrepre¬
sentative par value of $1. The “effective par” should be taken
at not less than $100 per share, in view of the $7 dividend. Hence
there are no assets available for the common stock, and its book
value is nil.

Current-asset Value and Cash-asset Value. —In addition to the
well-known concept of book value, we wish to suggest two others
of similar character, viz,, current-asset value and cash-asset value.

The current-asset value of a stock consists of the current assets
alone, minus all liabilities and claims ahead of the issue. It
excludes not only the intangible assets but the fixed and mis¬
cellaneous assets as well.

The cash-asset value of a stock consists of the cash assets
alone, minus all liabilities and claims ahead of the issue. 1 Cash
assets, other than cash itself, are defined as those directly equiva¬
lent to and held in place of cash. They include certificates of
deposit, call loans, marketable securities at market value and
cash-surrender-value of insurance policies.

The following is an example of the computation of the three
categories of asset value:

Otis Company (Cotton Goods)

Balance Sheet June 29, 1929

Assets Liabilities

1. Cash. $ 532,000 8. Accounts Payable.. $ 79,000

2. Call Loans. 1,200,000 9. Accrued Items, etc.. 291,000

3. Accounts Receivable 10. Reserve for Equip-

(less reserve). 1,090,000 ment, etc. 210,000

4. Inventory (less re- 11. Preferred Stock_ 400,000

serve of $425,000)* 1,648,000 12. Common Stock_ 4,079,000

5. Prepaid Items. 108,000 13. Earned Surplus.... 1,944,000

6. Investments. 15,000 14. Paid-in Surplus_ 1,154,000

7. Plant (less Deprecia¬

tion). 3,564,000

$8,157,000 $8,157,000

* Inventories before reserves are valued at cost or market, whichever is lower.

1 Cash assets per share of common are sometimes calculated without
deduction of any liabilities. In our opinion this is a useful concept only
when the other current assets exceed all liabilities ahead of the common.

BALANCE-SHEET ANALYSIS

678

A. Calculation of book value of common stock:

Total assets. $8,167,000

Less: Payables. $ 79,000

Accrued items... 291,000

Preferred stock. 400,000 770,000

$7,387,000

Add voluntary reserve of $425,000 subti acted

from inventory. 425,000

Net assets for common stock.$7,812,000

Book value per share (on 40,790 shares). ... $191

B. Calculation of current-asset value of the common stock:

Total current assets (items 1, 2, 3, and 4).$4,470,000

Add voluntary reserve against inventory . 425,000

$4,895,000

Less liabilities ahead of common (items 8, 9, and 11).... 770,000

Current assets available for common.$4,125,000

Current-asset value per share. $101

C. Calculation of cash-asset value of the common stock:

Total cash assets (items 1 and 2) . $1,732,000

Less liabilities ahead of common (items 8, 9, and 11). . . 770,000

Cash assets available for common.$ 962,000

Cash-asset value per share. $23.50

In these calculations it will be noted, first, that the inventory
is increased by restoring the reserve of $425,000 subtracted
therefrom in the balance sheet. This is done because the
deduction taken by the company is clearly a reserve for con¬
tingent decline in value that has not yet taken place. As such
it is entirely arbitrary or voluntary, and consistency of method
would require the analyst to regard it as a surplus item. The
same is true of the $210,000 “Reserve for Equipment and Other
Expenses,” which, as far as can be seen, represents neither an
actual liability nor a necessary deduction from the value of any
specific asset.

In June 1929 Otis Company common stock was selling at 35.
The reader will observe an extraordinary divergence between this
market price and the current-asset value of the shares. Its
significance will engage our attention later.

Practical Significance of Book Value. —The book value of a
common stock was originally the most important element in its
financial exhibit. It was supposed to show “the value” of the
shares in the same way as a merchant’s balance sheet shows

574

SECURITY ANALYSIS

him the value of his business. This idea has almost completely
disappeared from the financial horizon. The value of a com¬
pany’s assets as carried in its balance sheet has lost practically
all its significance. This change arose from the fact, first, that
the value of the fixed assets, as stated, frequently bore no relation¬
ship to the actual cost and, secondly, that in an even larger
proportion of cases these values bore no relationship to the figure
at which they would be sold or the figure which would be justified
by the earnings. The practice of inflating the book value of the
fixed property is giving way to the opposite artifice of cutting
it down to nothing in order to avoid depreciation charges, but
both have the same consequence of depriving the book-value
figures of any real significance. It is a bit strange, like a quaint
survival from the past, that the leading statistical services still
maintain the old procedure of calculating the book value per
share of common stock from many, perhaps most, balance sheets
that they publish.

Before we discard completely this time-honored conception
of book value, let us ask if it may ever have practical signifi¬
cance for the analyst. In the ordinary case, probably not.
But what of the cxtraordinaiy or extreme case? Let us consider
the four exhibits shown on p. 575, as representative of extreme
relationships between book value and market price.

No thoughtful observer could fail to be impressed by the
disparities revealed in the examples given. In the case of
General Electric and Commercial Solvents the figures proclaim
more than the bare fact that the market was valuing the shares
at many times their book value.' The stock ticker seems here to
register an aggregate valuation for these enterprises that is
totally unrelated to their standing as ordinary business enter¬
prises. In other words, these are in no sense business valuations;
they are products of Wall Street’s legerdemain, or possibly of
its clairvoyance.

Financial Reasoning vs. Business Reasoning .—We have here
the point that brings home more strikingly perhaps than any
other the widened rift between financial thought and ordinary
business thought. It is an almost unbelievable fact that Wall
Street never asks, “How much is the business selling for?”
Yet this should be the first question in considering a stock
purchase. If a business man were offered a 5% interest in some

BALANCE-SHEET ANALYSIS

575

concern for $10,000, his first mental process would be to multiply
the asked price by 20 and thus establish a proposed value of
$200,000 for the entire undertaking. The rest of his calculation
would turn about the question whether or not the business was a
“good buy” at $200,000.

Item

General

Electric

Pepperell

Manufac¬

turing

Price.

(1930) 95

(1932) 18

Number of shares.

28,850,000

97,600

Market value of common.

$2,740,000,000

S 1,760,000

Balance sheet. ...

(Dec. 1929)

(June 1932)

Fixed assets (less depreciation) ..

3 52,000,000

3 7,830,000

Miscellaneous assets.

183,000,000

230,000

Net current assets.

206,000,000

9,120,000

Total net assets.

Less bonds and preferred.

3 441,000,000
45,000,000

317,180,000

Book value of common. . ....

3 396,000,000

$17,180,000

Book value per share.

$13.75

$176

Item

Commercial

Solvents

Pennsyl¬
vania Coal
and Coke

Price.

Number of shares.

Market value of common.

Balance sheet.

Fixed assets (less depreciation).
Miscellaneous assets.

(July 1933) 57
2,493,000
3142,000,000
(Dec. 1932)

(July 1933) 3
165,000
$ 495,000
(Dec. 1932)
6,500,000
990,000
740,000

2,600,000

6,000,000

Net current assets.

Total assets for common....

Book value per share.

3 8,600,000
33.50

38,230,000

350

This elementary and indispensable approach has been prac¬
tically abandoned by those who purchase stocks. Of the
thousands who “invested” in General Electric in 1929-1930
probably only an infinitesimal number had any idea that they
were paying on the basis of about 2% billions of dollars for

576

SECURITY ANALYSIS

the company, of which over two billions represented a premium
above the money actually invested in the business. The price
of 57 established for Commercial Solvents in July 1933 was
more of a gambling phenomenon, induced by the expected
repeal of prohibition. But the gamblers in this instance were
acting no differently from those who call themselves investors,
in their blithe disregard of the fact that they were paying 140
millions for an enterprise with about 10 millions of resources.
(The fixed assets of Commercial Solvents, written down to
nothing in the balance sheet, had real value, of course, but not in
excess of a few millions.)

The contrast in the other direction shown by our examples is
almost as impressive. A going but unsuccessful concern like
Pennsylvania Coal and Coke can be valued in the market at
about one-sixteenth of its stated resources almost on the same
day as a speculatively attractive issue is bid for at sixteen times
its net worth. The Pepperell example is perhaps more striking
still, because of the unquestioned reality of the figures of book
value and also because of tho high reputation, large earnings
and liberal dividends of the enterprise covering a long stretch
of years. Yet part owners of this business—under the stress of
depression, it is true—were willing to sell out their interest at
one-tenth of the value that a single private owner would have
unhesitatingly placed upon it.

Recommendation .—These examples, extreme as they are,
suggest rather forcibly that the book value deserves at least a
fleeting glance by the public before it buys or sells shares in a
business undertaking. In any particular case the message
that the book value conveys may well prove to be inconse¬
quential and unworthy of attention. But this testimony should
be examined before it is rejected. Let the stock buyer, if he lays
any claim to intelligence, at least be able to tell himself, first,
what value he is actually setting on the business and, second, what
he is actually getting for his money in terms of tangible resources.

There are indeed certain presumptions in favor of purchases
made far below asset value and against those made at a high
premium above it. (It is assumed that in the ordinary case
the book figures may be accepted as roughly indicative of the
actual cash invested in the enterprise.) A business that sells
at a premium does so because it earns a large return upon its

BALANCE-SHEET ANALYSIS

577

capital; this large return attracts competition, and, generally
speaking, it is not likely to continue indefinitely. Conversely
in the case of a business selling at a large discount because of
abnormally low earnings. The absence of new competition, the
withdrawal of old competition from the field and other natural
economic forces may tend eventually to improve the situation
and restore a normal rate of profit on the investment.

Although this is orthodox economic theory, and undoubtedly
valid in a broad sense, we doubt if it applies with sufficient
certainty and celerity to make it useful as a governing factor
in common-stock selection. It may be pointed out that under
modern conditions the so-called “intangibles," e.g., good-will
or even a highly efficient organization, are every whit as real
from a dollars-and-cents standpoint as are buildings and machin¬
ery. 1 Earnings based on these intangibles may be even less
vulnerable to competition than those which require only a cash
investment in productive facilities. Furthermore, when con¬
ditions are favorable the enterprise with the relatively small
capital investment is likely to show a more rapid rate of growth.
Ordinarily it can expand its sales and profits at slight expense
and therefore more rapidly and profitably for its stockholders
than a business requiring a large plant investment per dollar
of sales.

We do not think, therefore, that any rules may reasonably be
laid down on the subject of book value in relation to market
price, except the strong recommendation already made that the
purchaser know what he is doing on this score and be satisfied
in his own mind that he is acting sensibly.

1 Judicial valuations of intangible assets (in the case of close corporations)
still seem to adhere to the old concept that they are less “real” than tangible
assets and thus need larger earnings, relatively, to support them. The
divergence between the stock market’s bases of valuation and those of
business men and the courts, as applied to private enterprises, would
provide excellent material for a critical study.

For a quantitative study leading to the conclusion that “good-will”
has, on the whole, proved more profitable than tangible assets, see Lawrence
N. Bloomberg, The Investment Value of Goodwill, Baltimore, 1938.

CHAPTER XLIII

SIGNIFICANCE OF THE CURRENT-ASSET VALUE

The current-asset value of a common stock is more likely to
be an important figure than the book value, which includes the
fixed assets. Our discussion of this point will develop the
following theses:

1. The current-asset value is generally a rough index of the liquidating
value.

2. A large number of common stocks sell for less than their current-asset
value and therefore sell below the amount realizable in liquidation.

3. The phenomenon of many stocks selling persistently below their
liquidating value is fundamentally illogical. It means that a serious error
is being committed, either: (a) in the judgment of the stock market, (6) in
the policies of the company’s management or (c) in the attitude of the
stockholders toward their property.

Liquidating Value.—By the liquidating value of an enterprise
we mean the money that the owners could get out of it if they
wanted to give it up. They might sell all or part of it to some
one else, on a going-concern basis. Or else they might turn
the various kinds of assets into cash, in piecemeal fashion, taking
whatever time is needed to obtain the best realization from each.
Such liquidations are of everyday' occurrence in the field of
private business. By contrast, however, they are very rare
indeed in the field of publicly owned corporations. It is true
that one company often sells out to another, usually at a price
well above liquidating value, also that insolvency will at times
result in the piecemeal sale of the assets; but the voluntary with¬
drawal from an unprofitable business, accompanied by the careful
liquidation of the assets, is an infinitely more frequent happening
among private than among publicly owned concerns. This
divergence is not without its cause and meaning, as we shall
show later.

Realizable Value of Assets Varies with Their Character.—A
company’s balance sheet docs not convey exact information

678

BALANCE-SHEET ANALYSIS

579

as to its value in liquidation, but it does supply clues or hints
which may prove useful. The first rule in calculating liquidating
value is that the liabilities are real but the value of the assets
must be questioned. This means that all true liabilities shown on
the books must be deducted at their face amount. The value to
be ascribed to the assets, however, will vary according to their
character. The following schedule indicates fairly well the
relative dependability of various types of assets in liquidation.

% of liquidating value
to book value

Type of asset

Normal

range

Rough

average

Current assets:

Cash assets (including securities at
market).

100

Receivables (less usual reserves) *.. .

75-90

Inventories (at lower of cost or
market).

60-75

66%

Fixed and miscellaneous assets:

(Real estate, buildings, machinery,
equipment, nonmarketable invest¬
ments, intangibles, etc.).

1-50

15 (approx.)

* Note: Retail installment accounts must be valued for liquidation at a lower rate.
Range about 30 to 60 %. Average about 50 %.

Calculation Illustrated .—The calculation of approximate liqui¬
dating value in a specific case is illustrated as follows:

Example: White Motor Company. (See next page.)

Object of This Calculation .—In studying this computation
it must be borne in mind that our object is not to determine the
exact liquidating value of White Motor but merely to form a
rough idea of this liquidating value in order to ascertain whether
or not the shares are selling for less than the stockholders could
actually take out of the business. The latter question is answered
very definitely in the affirmative. With full allowance for pos¬
sible error, there was no doubt at all (in 1931) that White Motor
would liquidate for a great deal more than $8 per share, or $5,200,-
000 for the company. The striking fact that the cash assets alone
considerably exceed this figure, after deducting all liabilities ,
completely clinched the argument on this score.

580

SECURITY ANALYSIS

Current-asset Value a Rough Measure of Liquidating Value .—
The estimated values in liquidation as given for White Motor
are somewhat lower in respect of inventories and somewhat
higher as regards the fixed and miscellaneous assets than one

White Motor Company
Capitalization: 650,000 shares of common stock.

Price in December 1931: $8 per share.

Total market value of the company: $5,200,000.

Balance Sheet, December 31, 1931 (000 omitted)

Item

Book

value

Estimated liquidat¬
ing value

%of

book value

Amount

Cash .

$ 4,0571

U.S. Govt, and New York City bonds ...

4'573 J

100

$ 8,600

Receivables (less reserves).

5,611

4,500

Inventory (lower of cost or market).

9,219

4,600

Total current assets.

$23,460

*17,700

Less current liabilities.

1,353

1,400

Net current assets.

$16,300

Plant account.

16,036\

Less depreciation.

7,4911

Plant account, net.

$ 8,545^

4,000

Investments in subsidiaries, etc.

4,9961

Deferred charges.

388]

Good-will.

5,389/

Total net assets for common stock.

$41,425

$20,300

Estimated liquidating value per share..

... $31

Book value per share.

... 55

Current-asset value per share.
Cash-asset value per share....
Market price per share.

$11

might be inclined to adopt in other examples. We are allowing
for the fact that motor-truck inventories are likely to be less
salable than the average. On the other hand some of the assets

BALANCE-SHEET ANALYSIS

581

listed as noncurrent, in particular the investment in White
Motor Securities Corporation, would be likely to yield a larger
proportion of their book values than the ordinary property
account. It will be seen that White Motors estimated liquidat¬
ing value (about $31 per share) was not far from the current-asset
value ($34 per share). In the typical case it may be said that the
noncurrent assets are likely to realize enough to make up most
of the shrinkage suffered in the liquidation of the current assets.
Hence our first thesis, viz., that the current-asset value affords
a rough measure of the liquidating value.

Prevalence of Stocks Selling below Liquidating Value.—Our
second point is that for some years past a considerable number of
common stocks have been selling in the market well below their
liquidating value. Naturally the percentage was largest during
the depression. But even in the bull market of 1926-1929
instances of this kind were by no means rare. It will be noted
that the striking case of Otis Company, presented in the last
chapter, occurred during June 1929, at the very height of the
boom. The Northern Pipe Line example, given in Chap. XLI,
dates from 1926. On the other hand, our Pepperell and White
Motor illustrations were phenomena of the 1931-1933 collapse.

It seems to us that the most distinctive feature of the stock
market of those three years was the large proportion of issues
which sold below their liquidating value. Our computations
indicate that over 40% of all the industrial companies listed
on the New York Stock Exchange were quoted at some time in
1932 at less than their net current assets. A considerable number
actually sold for less than their cash-asset value, as in the case
of White Motor. 1 On reflection this must appear to be an
extraordinary state of affairs. The typical American corpora¬
tion was apparently worth more dead than alive. The owners
of these great businesses could get more for their interest by
shutting up shop than by selling out on a going-concern basis.

In the recession of 1937-1938 this situation was repeated on
a smaller scale. Available data indicate that 20.5% of the
industrial companies listed on the New York Stock Exchange
sold in early 1938 at less than their net-current-asset value.
(At the close of 1938, when the general price level was by no

1 See Appendix Note 62, p. 801, for a representative list of issues selling
for less than liquidating value in 1932.

582

SECURITY ANALYSIS

means abnormally low, a total of 54 companies out of 648 indus¬
trials studied sold for less than their net current assets. 1 )

It is important to observe that these widespread discrepancies
between price and current-asset value are a comparatively
recent development. In the severe market depression of 1921
the proportion of industrial stocks in this class was quite small.
Evidently the phenomena of 1932 (and 1938) were the direct out¬
growth of the new-era doctrine which transferred all the tests of
value to the income account and completely ignored the balance-
sheet picture. In consequence, a company without current
earnings was regarded as having very little real value, and it was
likely to sell in the market for the merest fraction of its realizable
resources. Most of the sellers were not aware that they were
disposing of their interest at far less than its scrap value. Many,
however, who might have known the fact would have justified
the low price on the ground that the liquidating value was of no
practical importance, since the company had no intention of
liquidating.

Logical Significance of This Phenomenon.—This brings us to
the third point, viz., the logical significance of this a subliquidat¬
ing-value ,7 phenomenon from the standpoint of the market, of
the managements and of the stockholders. The whole issue
may be summarized in the form of a basic principle, viz.:

When a common stock sells persistently below its liquidating
value, then either the price is too low or the company should be
liquidated . Two corollaries may be deduced from this principle:

Corollary I. Such a price should impel the stockholders to raise the
question whether or not it is in their interest to continue the business.

Corollary II. Such a price should impel the management to take all
proper steps to correct the obvious disparity between market quotation and
intrinsic value, including a reconsideration of its own policies and a frank
justification to the stockholders of its decision to continue the business.

The truth of the principle above stated should be self-evident.
There can be no sound economic reason for a stocks selling con¬
tinuously below its liquidation value. If the company is not
worth more as a going concern than in liquidation, it should bo
liquidated. If it is worth more as a going concern, then the stock
should sell for more than its liquidating value. Hence, on either
premise, a price below liquidating value is unjustifiable.

1 See Appendix Note 61, p. 790, for other details on this point.

BALANCE-SHEET ANALYSIS

583

Twofold Application of Foregoing Principle .—Stated in the
form of a logical alternative, our principle invites a twofold
application. Stocks selling below liquidation value are in many
cases too cheap and so offer an attractive medium for purchase.
We have thus a profitable field here for the technique of security
analysis. But in many cases also the fact that an issue sells
below liquidating value is a signal that mistaken policies are
being followed and that therefore the management should take
corrective action—if not voluntarily, then under pressure from
the stockholders. Let us consider these two lines of inquiry in
order.

ATTRACTIVENESS OF SUCH ISSUES AS COMMITMENTS

Common stocks in this category practically always have an
unsatisfactory trend of earnings. If the profits had been
increasing steadily, it is obvious that the shares would not sell
at so low a price. The objection to buying these issues lies
in the probability, or at least the possibility, that earnings will
decline or losses continue and that the resources will be dissi¬
pated and the intrinsic value ultimately become less than the
price paid. It may not be denied that this does actually happen
in individual cases. On the other hand, there is a much wider
range of potential developments which may result in establishing
a higher market price. These include the following:

1. The creation of an earning power commensurate with the company’s
assets. This may result from:

а. General improvement in the industry.

б. Favorable change in the company’s operating policies, with or
without a change in management. These changes include more
efficient methods, new products, abandonment of unprofitable lines,
etc.

2. A sale or merger, because some other concern is able to utilize the
resources to better advantage and hence can pay at least liquidating
value for the assets.

3. Complete or partial liquidation.

Examples of Effect of Favorable Developments on Such
Issues. General Improvement in the Industrtg .—Examples already
given, and certain others, will illustrate the operation of these
various kinds of favorable developments. In the case of Pep-
perell the low price of coincided with a large loss for the

584

SECURITY ANALYSIS

year ended June 30, 1932. In the following year conditions
in the textile industry improved; Pepperell earned over $9 per
share and resumed dividends; consequently the price of the stock
advanced to 100 in January 1934 and to 149% in 1936.

Changes in Operating Policies .—Hamilton Woolen Company,
another example in the textile field, is a case of individual rather
than of general improvement. For several years prior to 1928
the company had operated at substantial losses, which amounted
to nearly $20 and $12 per share in 1926 and 1927, respectively.
Late in 1927 the common stock sold at $13 per share, although the
company had net current assets of $38.50 per share at that time.
In 1928 and 1929 changes in management and in managerial
policies were made, new lines of product and direct sales methods
were introduced, and certain phases of production were reor¬
ganized. This resulted in greatly improved earnings which
averaged about $5.50 per share during the succeeding four years,
and within a single year the stock had risen to a price of about
$40. 1

Sale or Merger .—The White Motor instance is typical of the
genesis and immediate effect of a sale or merger, as applied to an
issue selling for less than liquidating value. (The later develop¬
ments, however, were quite unusual.) The heavy losses of White
Motor in 1930-1932 impelled the management to seek a new
alignment. Studebaker Corporation believed it could combine
its own operations with those of White to mutual advantage, and
it was greatly attracted by Whited large holdings of cash. Hence
in September 1932 Studebaker offered to purchase all White
Motor’s stock, paying for each share as follows:

$5 in cash.

$25 in 10-year 6 % notes of Studebaker Corporation.

1 share of Studebaker common, selling for about $10.

It will be seen that these terms of purchase were based not
on the recent market price of White—below $7 per share—but
primarily upon the current-asset value. White Motor shares
promptly advanced to 27 and later sold at the equivalent of
3W

1 For the later history of Hamilton Woolen Company, see pp. 603-605.

•An extraordinary sequel of this transaction was the receivership of
Studebaker Corporation in April 1933, ostensibly caused by the opposition

BALANCE-SHEET ANALYSIS

585

An interesting example of the same kind, but of more recent
date, is afforded by Standard Oil Company of Nebraska. The
facts may be outlined as follows:

Early in 1939 the stock was se.lling at about $6, representing
a total valuation of $1,000,000 for 161,000 shares comprising
the entire capitalization. The December 31, 1938, balance
sheet is summarized in the appended table.

Assets Liabilities

Fixed and miscellaneous Current liabilities. $ 176,000

assets (net). $2,794,000 Capital stock and sur-

Cash assets. 1,155,000 plus. 4,734,000

Other current assets. . . 961,000 $4,910,000

$4,910,000

(Net) Cash assets per share. $ 6.07

Net current assets per share. 12.05

Net tangible assets per share. 29.33

The company was engaged in the distribution of petroleum
products in Nebraska. It was carrying on an annual business of
some $5,000,000 without appreciable profit. For the years 1935-
1938 the reported earnings before depreciation averaged $0.69
per share; after “expended depreciation” there was an average
profit of $0.39 per share; and after depreciation as taken by the
company there was an average loss of $0.39 per share.

Here was a company clearly selling for much less than liquidat¬
ing value, the reason being its unsatisfactory earnings record.
There was good reason to believe, however, that the company was
really worth more than bare liquidating value, because the outlet
it provided for gasoline, etc., would make its numerous retail and
bulk stations a desirable acquisition for some large refining
company.

In April 1939 private interests offered to pay $12 per share for
66 %% of the outstanding stock. This bid failed of acceptance
by a sufficient majority, but it was followed immediately by an
offer to pay $17.50 per share, made by Standard Oil Company
of Indiana, the refiner that had been supplying Standard Oil
Company of Nebraska with its gasoline and that evidently was

of minority stockholders of White Motor to a merger of the two companies.
But this development is quite unrelated to our point of discussion, which
turns upon the fact that in a sale or merger full recognition should always be,
and is ordinarily, given to liquidating value, even though the current market
price may be much lower.

686

SECURITY ANALYSIS

loath to lose this important outlet. The deal was promptly-
ratified; hence the stock of Standard Oil Company of Nebraska
nearly tripled in value during a four-month’s period in which the
general market had suffered a decline. 1

Complete Liquidation .—Mohawk Mining Company supplies
an excellent example of a cash profit equivalent to a large
advance in market value caused by the actual liquidation of the
enterprise.

In December 1931 the stock sold at $11 per share, representing
a total valuation of $1,230,000 for the 112,000 shares outstanding.
The balance sheet at the end of 1931 showed the following:

Cash and marketable securities at market. $1,381,000

Receivables. 9,000

Copper at market value, about. 1,800,000

Supplies. 71,000

$3,261,000

Less current liabilities. 68,000

Net current assets. $3,193,000

Fixed assets, less depreciation and depletion. 2,460,000

Miscellaneous assets. 168,000

Total assets for common stock. $5,821,000

Book value per share 1 . $52

Current-asset value per share 1 . 28.50

Cash-asset value per share 1 . 11.75

Market price per share. 11

1 After reducing securities and copper inventory to market value.

Shortly thereafter the management decided to liquidate the
property. Within the years 1932-1934 regular and liquidating
dividends were paid, aggregating $28.50 per share. It will be
noted that the amount actually received in liquidation proved
indentical with the current-asset value just before the liquidation
began, and it was 2^ times the ruling market price at that time.

Partial Liquidation .—Northern Pipe Line Company and Otis
Company, already discussed, are examples of the establishment
of a higher market value through partial liquidation. The two
companies made the exhibits as shown in the table on p. 687.

In September 1929 Otis Company paid a special dividend of
$4 per share, and in 1930 it made a distribution of $20 in partial
liquidation, reducing the par value from $100 to $80. In April

1 See I. Benesch and Sons, and United Shipyards "A" in the table on
p. 604 for other examples of a rise in price due to sale of properties.

BALANCE-SHEET ANALYSIS

587

1931 the shares sold at 45 and in April 1932 at 41. These
prices were higher than the quotation in June 1929, despite the
distributions of $24 per share made in the interim, and despite
the fact also that the general market level had changed from
fantastic inflation to equally fantastic deflation. Later the com¬
pany went out of business altogether and paid its stockholders
an additional $74 per share in liquidation—making the total
received by them $102 per share since June 1929 (inclusive
of other dividends in 1929-1934 amounting to $4 per share). 1

Item

Northern
Pipe Line

Otis

Company

Date.

1926

June 1929

Market price.

$ G4

$ 35

Cash-asset value per share.

23M

101

Current-asset value per share.

Book value per share.

11G

191

Northern Pipe Line Company distributed $50 per share to its
stockholders in 1928, as a return of capital, t.c., partial liquida¬
tion. This development resulted in an approximate doubling
of the market price between 1926 and 1928. Later a second
distribution of $20 per share was made, so that the stockholders
received more in cash than in the low market price of 1925
and 1926, and they also retained their full interest in the pipe¬
line business. Similar liberal distributions were made by most
of the pipe-line companies of the so-called Standard Oil group.
(Note also the partial liquidation of Davis Coal and Coke Com¬
pany, described on p. 563.)

Discrimination Required in Selecting Such Issues.—There is
scarcely any doubt that common stocks selling well below
liquidating value represent on the whole a class of undervalued
securities. They have declined in price more severely than the
actual conditions justify. This must mean that on the whole
these stocks afford profitable opportunities for purchase. Never¬
theless, the securities analyst should exercise as much dis¬
crimination as possible in the choice of issues falling within this
category. He will lean toward those for which he sees a fairly

1 For other examples of liquidation bringing stockholders more than the
previous market price see the table on p. 604.

588

SECURITY ANALYSIS

imminent prospect of some one of the favorable developments
listed above. Or else he will be partial to such as reveal other
attractive statistical features besides their liquid-asset position,
e.g.j satisfactory current earnings and dividends or a high average
earning power in the past. The analyst will avoid issues that
have been losing their current assets at a rapid rate and show no
definite signs of ceasing to do so.

Examples: This latter point will be illustrated by the following
comparison of two companies, the shares of which sold well
below liquidating value early in 1933.

Item

Manhattan Shirt Company

llupp Motor Car
Corporation

Price, January 1933.

(

Total market value of Company.

$1,476,000

$3,323,000

Balance sheet:

Nov. 30, 1932

Nov. 30, 1929

Dec. 31, 1932

Dec. 31, 1929

Preferred stock at par. . .

Number of shares of common..

246,000

$ 300,000

281,000

1,329,000

1,475,000

Cash assets.

$1,961,000

$ 886,000

$ 4,615,000

$10,156,000

Receivables .

771,000

2,621,000

226,000

1,246,000

Inventories.

1,289,000

4,330,000

2,115,000

8,481,000

Total current assets.

$4,021,000

$7,836,000

$ 6,956,000

$19,883,000

Current liabilities.

100,000

2,674,000

1,181,000

2,541,000

Net current assets.

$3,921,000

$5,262,000

$ 5,775,000

$17,342,000

Other tangible assets.

1,124,000

2,066,000

9,757,000

17,870,000

Total assets for common (and
preferred).

$5,046,000

$7,328,000

$15,532,000

$35,212,000

Cash-asset value per share.

$ 7.60

Nil

$2,625

$ 5.125

Current-asset value per share..

16.00

$17.50

4.375

11.75

Both of these companies disclose an interesting relationship
of current assets to market price at the close of 1932. But a
comparison with the balance-sheet situation of three years
previously will yield much more satisfactory indications for
Manhattan Shirt than for Hupp Motors. The latter concern
had lost more than half of its cash assets and more than 60% of
its net current assets during the depression period. On the other
hand the current-asset value of Manhattan Shirt common was
reduced by only 10% during these difficult times, and further-

BALANCE-SHEET ANALYSIS

580

more its cash-asset position was greatly improved. The latter
result was obtained through the liquidation of receivables and
inventories, the proceeds of which paid off the 1929 bank loans
and largely increased the cash resources.

From the viewpoint of past indications, therefore, the two
companies must be placed in different categories. In the Hupp
Motors case, we should have to take into account the possibility
that the remaining excess of current assets over market price
might soon be dissipated. This is not true so far as Manhattan
Shirt is concerned, and in fact the achievement of the company
in strengthening its cash position during the depression must be
given favorable consideration. We shall recur later to this
phase of security analysis, viz. f the comparison of balance sheets
over a period in order to determine the true progress of an
enterprise. The former point—that attention should be paid
also to the past earnings record—may be brought home by a
brief comparison of two companies in early 1939.

Item

Ely & Walker Dry
Goods Co.

Pacific Mills

Price, January, 1939 .

Per share:

Dec. 31, 1932 Dec. 31, 1938

Dec. 31, 1932

Dec. 31, 1938

Net current assets .

$30.00 $39.50

$26.95

$24 50

Net tangible assets

37.73 46 42

90.85

79 50

Average earnings, 1933-1938 .

1 82

* 41(d)

Average dividend, 1933-1938. ..

1.25

.50

The losses of Pacific Mills did not have a serious effect upon the
balance-sheet position because they have come mainly out of the
balance sheet via the depreciation allowance. But unless there
were special reasons to expect a reversal of the operating results,
the analyst would obviously prefer Ely and Walker as an invest¬
ment purchase.

Bargains of This Type. —Common stocks that (1) are selling
below their liquid-asset value, (2) are apparently in no danger of
dissipating these assets, and (3) have formerly shown a large
earning power on the market price, may be said truthfully to
constitute a class of investment bargains . They are indubitably
worth considerably more than they are selling for, and there is a
reasonably good chance that this greater worth will sooner or

590

SECURITY ANALYSIS

later reflect itself in the market price. At their low price these
bargain stocks actually enjoy a high degree of safety, meaning
by safety a relatively small risk of loss of principal.

It may be pointed out, however, that investment in such
bargain issues needs to be carried on with some regard to general
market conditions at the time. Strangely enough, this is a type
of operation that fares best, relatively speaking, when price levels
are neither extremely high nor extremely low. The purchase of
“cheap stocks” when the market as a whole seems much higher
than it should be, e.g., in 1929 or early 1937, will not work out
well, because the ensuing decline is likely to bear almost as
severely on these neglected or unappreciated issues as on the
general list. On the other hand, when all stocks are very cheap
—as in 1932—there would seem to be fully as much reason to
buy undervalued leading issues as to pick out less popular
stocks, even though these may be selling at even lower prices by
comparison.

A Common Stock Representing the Entire Business Cannot Be
Less Safe than a Bond Having a Claim to Only a Part Thereof .—In
considering these issues it will be helpful to apply the converse
of the proposition developed earlier in this book with reference
to senior securities. We pointed out (Chap. XXVI) that a
bond or preferred stock could not be worth more than its value
would be if it represented full ownership of the company, i.e. f
if it were a common stock without senior claims ahead of it.
The converse is also true. A common stock cannot be less safe
than it would be if it were a bond, i.e., if instead of representing
full ownership of the company it were given a fixed and limited
claim, with some new common stock created to own what was
left. This idea, which may appear somewhat abstract at first,
may be clarified by a concrete comparison between a common
stock and a bond issue of the types just described. Two com¬
panies in the investment-trust field are particularly well suited
to illustrate our point, because they were both organized by the
same banking interests, and they have identical officers. .

Our table (p. 591) should make clear that Shawmut Association
stock cannot be less safe intrinsically than the Investment Trust
senior debentures at 85. For, with the same management behind
them, the stock investment has behind it 180% in assets,
whereas the bonds are protected by only 122% (of their market

BALANCE-SHEET ANALYSIS

591

price) in assets. In addition to having this greater protection
the Association stock represents the entire ownership of the
company’s assets, whereas the interest of the Investment Trust
bonds is limited to their principal amount, the balance of the
equity belonging to the junior holders. (In fact this junior
equity can be fairly substantial, as measured by market price,
even when the bonds are selling at a considerable discount.)

As of December 1939

Shawmut Association

Shawmut Bank Investment
Trust

Bonds.

None

$3,040,000 Senior Debenture

Stock.

390,000 ah. @ 10K $4,000,000

4>28 and 5s © 85 (average)
- $2,585,000

$950,000 Junior Debenture
6s @ 50 (est) - $480,000
75,000 ah. @ 3M 260,000

Total capitalization . .

$4,000,000

$3,325,000

Net asset value (September

1939) .

7,201,000

(November 1939) 3,153,000

Ratio: Senior bonds at mar¬

ket to net assets

82%

Ratio: Total capitalization

at market to net assets

55%

107%

12 months’ investment in¬

come 1 .

(To September 30) 198,000

(To November 30) 114,000

Per cent earned on capitali¬

zation at market . ...

5.0

3.5

1 Excluding gain or loss on security sales.

That the Shawmut Association stock is more attractive than
the Investment Trust debentures at the prices quoted is scarcely
open to challenge. Undoubtedly, also, the investor who would
consider the bond issue to be “safer” than the Association shares
is being misled by the form into overlooking the essence . Yet
something remains to be said of the effect of these diverse forms
upon the experience of the investor and consequently upon his
attitude. The Investment Trust bonds do carry a certain assur¬
ance of continued income, because interest must be paid regularly
or else the company faces insolvency. It is true for the same
reason that special efforts will be made to pay them off at or
before maturity in 1942 and 1952. Therefore we find that the
company has a special inducement to buy in bonds at a discount
—since they must ultimately be paid at par—and thus one-third
of the issue has been reacquired. This policy has served to main-

092

SECURITY ANALYSIS

tain the market price to an important extent and to improve the
position of the remaining bonds.

None of this is true with respect to the Shawmut Association
shares. They have in fact received continuous dividends since
1929, averaging 65 cents, or 6K % the current price. But the
rate has been variable, and the average stockholder feels that he
is at the mercy of the management's decisions. (This is not
entirely so in fact, since the penalty clauses in the Revenue Act
virtually compel disbursement of the net income realized by
investment trusts.) Nor has the market price been maintained
by company repurchases at a reasonable discount from break-up
value, so that the investor has been unable to look to the manage¬
ment to save him from the hard necessity of sacrificing his shares
at as much as 50% below their intrinsic worth.

In the 1934 edition we illustrated this same point by consider¬
ing American Laundry Machinery stock at its price of 7 in
January 1933, which was equivalent to $4,300,000 for the entire
company—as compared with over $4,000,000 in cash, $21,000,000
in net current assets, $27,000,000 in net tangible assets and
10-year average earnings of over $3,000,000 (including, however,
a loss of $1,000,000 in 1932). The last two paragraphs of the
chapter were as follows:

Wall Street would have considered American Laundry Machin¬
ery stock “unsafe” at 7, but it would unquestionably have
accepted a $4,500,000 bond issue of the same company. Its
“reasoning” would have run that the interest on the bond was
sure to be continued but that the 40-cent dividend then being
paid on the stock was very insecure. In one case the directors
had no choice but to pay interest and therefore would surely
do so; in the other case the directors could pay or not as they
saw fit and therefore would very likely suspend the dividend.
But Wall Street is here confusing the temporary continuance of
income with the more fundamental question of safety of principal.
Dividends paid to common-stock holders do not in themselves
make the stock any safer. The directors are merely turning
over to the stockholders part of their own property; if the money
were left in the treasury, it would still be the stockholder's
property. There must therefore be an underlying fallacy in
assuming that if the stockholders were given the power to compel
payment of income — i.e., if they were made bondholders in

BALANCE-SHEET ANALYSIS

593

whole or in part —their position would thus be made intrinsically
sounder. It is little short of idiocy to assume that the stock
holders would be better off if they surrendered their complete
ownership of the company in exchange for a limited claim against
the same property at the rate of 5 or 6% on the investment.
This is exactly what the public would do if it were willing to
buy a $4,500,000 bond issue of American Laundry Machinery
but would reject as “unsafe” the present common stock at $7
per share.

Nevertheless, Wall Street persists in thinking in these irrational
terms, and it does so in part with practical justification. Some¬
how or other, common-stock ownership does not seem to give
the public the same powers and possibilities—the same values, in
short—as are vested in the private owners of a business. This
brings us to the second line of reasoning on the subjects of stocks
selling below liquidating value.

CHAPTER XLIV

IMPLICATIONS OF LIQUIDATING VALUE.
STOCKHOLDER-MANAGEMENT RELATIONSHIPS

Wall Street holds that liquidating value is of slight importance
because the typical company has no intention of liquidating.
This view is logical, as far as it goes. When applied to a stock
selling below break-up value, the Wall Street view may be
amplified into the following: “Although this stock would liqui¬
date for more than its market price, it is not worth buying
because (1) the company cannot earn a satisfactory profit
and (2) it is not going to liquidate. In the previous chapter we
suggested that the first assumption is likely to be wrong in a
number of instances, for, although past earnings may have been
disappointing, there is always a chance that through external
or internal changes the concern may again earn a reasonable
amount on its capital. But in a considerable proportion of cases
the pessimism of the market will at least appear to be justified.
We are led, therefore, to ask the question: “Why is it that no
matter how poor a corporation’s prospects may seem, its owners
permit it to remain in business until its resources are exhausted? ”

The answer to this question takes us into the heart of one
of the strangest phenomena of American finance—the relations
of stockholders to the businesses that they own. The subject
transcends in its scope the narrow field of security analysis,
but we shall discuss it here briefly because there is a distinct
relationship between the value of securities and the intelligence
and alertness of those who own them. The choice of a common
stock is a single act; its ownership is a continuing process.
Certainly there is just as much reason to exercise care and
judgment in being as in becoming a stockholder.

Typical Stockholder Apathetic and Docile. —It is a notorious
fact, however, that the typical American stockholder is the most
docile and apathetic animal in captivity. He does what the
board of directors tell him to do and rarely thinks of asserting

694

BALANCE-SHEET ANALYSIS

595

his individual rights as owner of the business and employer of
its paid officers. The result is that the effective control of
many, perhaps most, large American corporations is exercised
not by those who together own a* majority of the stock but by a
small group known as “the management.” This situation
has been effectively described by Berle and Means in their
significant work The Modern Corporation and Private Property .
In Chap. I of Book IV the authors say:

It is traditional that a corporation should be run for the benefit of its
owners, the stockholders, and that to them should go any profits which
are distributed. We now know, however, that a controlling group may
hold the power to divert profits into their own pockets. There is no
longer any certainty that a corporation will in fact be run primarily
in the interests of the stockholders. The extensive separation of owner¬
ship and control, and the strengthening of the powers of control, raise a
new situation calling for a decision whether social and legal pressure
should be applied in an effort to insure corporate operation primarily
in the interests of the owners or whether such pressure shall be applied
in the interests of some other or wider group.

Again (page 335,) the authors restate this view in their con¬
cluding chapter as follows:

... A third possibility exists, however. On the one hand, the
owners of passive property, by surrendering control and responsibility
over the active property, have surrendered the right that the corporation
should be operated in their sole interest—they have released the com¬
munity from the obligation to protect them to the full extent implied
in the doctrine of strict property rights. At the same time, the con¬
trolling groups, by means of the extension of corporate powers, have in
their own interest broken the bars of tradition which require that the
corporation be operated solely for the benefit of the owners of passive
property. Eliminating the sole interest of the passive owner, however,
does not necessarily lay a basis for the alternative claim that the new
powers should be used in the interest of the controlling groups. The
latter have not presented, in acts or words, any acceptable defense of the
proposition that these powers should be so used. No tradition supports
that proposition. The control groups have, rather, cleared the way
for the claims of a group far wider than either the owners or the control.
They have placed the community in a position to demand that the
modern corporation serve not alone the owners or the control but all
society.

590

SECURITY ANALYSIS

Plausible but Partly Fallacious Assumptions by Stock¬
holders. —Alert stockholders—if there are any such—are not
likely to agree fully with the conclusion of Messrs. Berle and
Means that they definitely have “ surrendered the right that
the corporation should be operated in their sole interest.”
After all, the American stockholder has abdicated not inten¬
tionally but by default. He can reassert the rights of control
that inhere in ownership. Quite probably he would do so if he
were properly informed and guided. In good part his docility
and seeming apathy are results of certain traditional but unsound
viewpoints which he seems to absorb by inheritance or by con¬
tagion. These cherished notions include the following:

1. The management knows more about the business than the stockholders
do, and therefore its judgment on all matters of policy is to be accepted.

2. The management has no interest in or responsibility for the prices at
which the company's securities sell.

3. If a stockholder disapproves of any major policy of the management,
his proper move is to sell his stock.

Assumed Wisdom and Efficiency of Management Not Always
Justified. —These statements sound plausible, but they are in
fact only half truths—the more dangerous because they are not
wholly false. It is nearly always true that the management is
in the best position to judge which policies are most expedient.
But it does not follow that it will always either recognize or
adopt the course most beneficial to the shareholders. It may
err grievously through incompetence. Stockholders of any given
company appear to take it for granted that their management is
capable. Yet the art of selecting stocks is said to turn largely
on choosing the well-managed enterprise and rejecting others.
This must imply that many companies are poorly directed.
Should not this mean also that the stockholders of any company
should be open-minded on the question whether its management
is efficient or the reverse?

Interests of Stockholders and Officers Conflict at Certain
Points. —But a second reason for not always accepting implicitly
the decisions of the management is that on certain points the
interests of the officers and the stockholders may be in conflict.
This field includes the following:

1. Compensation to officers—Comprising salaries, bonuses, options to
buy stock.

BALANCE-SHEET ANALYSIS 597

2. Expansion of the business—Involving the right to larger salaries and
the acquisition of more power and prestige by the officers.

3. Payment of dividends—Should the money earned remain under the
control of the management or pass into the hands of the stockholders?

4. Continuance of the stockholders' investment in the company—Should
the business continue as before, although unprofitable, or should part of the
capital be withdrawn, or should it be wound up completely?

5. Information to stockholders—Should those in control be able to benefit
through having information not given to stockholders generally?

On all of these questions the decisions of the management
are interested decisions, and for that reason they require scrutiny
by the stockholders. We do not imply that corporate manage¬
ments are not to be trusted. On the contrary, the officers
of our large corporations constitute a group of men above the
average in probity as well as in ability. But this does not
mean that they should be given carte blanche in all matters
affecting their own interests. A private employer hires only
men he can trust, but he does not let these men fix their own
salaries or decide how much capital he should place or leave in
the business.

Directors Not Always Free from Self-interest in Connec¬
tion with These Matters. —In publicly owned corporations
these matters are passed on by the board of directors, whom the
stockholders elect and to whom the officials are responsible.
Theoretically, the directors will represent the stockholders'
interests, when need be, as against the opposing interests of the
officers. But this cannot be counted upon in practice. In
many companies a majority, and in most companies a substantial
part, of the board is composed of paid officials. The directors
who are not officers are frequently joined by many close ties
to the chief executives. It may be said in fact that the officers
choose the directors more often than the directors choose the
officers. Hence the necessity remains for the stockholders to
exercise critical and independent judgments on all matters
where the personal advantage of the officers may conceivably
be opposed to their own. In other words, in this field the usual
presumption of superior knowledge and judgment on the part
of the management should not obtain, and any criticism offered
in good faith deserves careful consideration by the stockholders.

Abuse of Managerial Compensation .—Numerous cases have
come to light in which the actions of the management in the

598

SECURITY ANALYSIS

matter of its own compensation have been open to serious
question. Most of these relate to the years before 1933. In
the case of Bethlehem Steel Corporation, cash bonuses clearly
excessive in amount were paid. In the case of American Tobacco
Company, rights to buy stock below the market price, of an
enormous aggregate value, were allotted to the officers. These
privileges to buy stock are readily subject to abuse. In the case
of Electric Bond and Share Company, the management permitted
itself to buy many shares of stock at far below market price.
When later the price of the stock collapsed to a figure less than
the subscription price, the obligation to pay for the shares was
cancelled, and the sums already paid were returned to the officers.
A similar procedure was followed in the case of White Motor
Company, which will be more fully discussed later in this chapter.

Some of these transactions are explained, and partly justified,
by the extraordinary conditions of 1928-1932. Others are
inexcusable from any point of view. Nevertheless, human
nature being what it is, such developments are not in the least
surprising. They do not really reflect upon the character of
corporate managements but rather on the patent unwisdom of
leaving such matters within the virtually uncontrolled discretion
of those who are to benefit by their own decisions.

The new regulations have done much to dispel the mist of
secrecy that formerly shrouded the emoluments and stockhold¬
ings of corporate officials. Information on salaries, bonuses and
stock options must be filed in connection with new security
offerings, with the registration of issues on a national exchange,
with the subsequent annual reports to the Commission and with
the solicitation of proxies. 1 Although these data are not com¬
plete, they are sufficient for the practical purpose of advising
the stockholders as to the cost of their management. Similarly,
stockholdings of officers, directors and those owning 10% of a
stock issue must be revealed monthly.

Since this information is not too readily accessible to the
individual stockholder, the statistical agencies could further
improve their already excellent service by subjoining the salary

1 Also, under provisions of the Revenue Act of 1936 the Treasury pub¬
lished the names and compensation of all corporate officers receiving over
$15,000 in that year. The Revenue Act of 1938 requires these data for
salaries of $75,000 or more, beginning with 1938.

BALANCE-SHEET ANALYSIS 599

and stockholding data to their annual lists of officers and
directors.

In recent years the question of excessive compensation to
management has excited considerable attention, and the public
understands fairly well that here is a field where the officers'
views do not necessarily represent the highest wisdom. It is
not so clearly realized that to a considerable extent the same
limitations apply in matters affecting the use of the stock¬
holders' capital and surplus. We have alluded to certain aspects
of this subject in our discussion of dividend policies (Chap.
XXIX). It should be evident also that the matter of raising
new capital for expansion is affected by the same reasoning as
applies to the withholding of dividends for this purpose.

Wisdom of Continuing the Business Should Be Considered.—
A third question, viz., that of retaining the stockholder's capital
in the business, involves considerations that are basically identi¬
cal. Managements are naturally loath to return any part of
the capital to its owners, even though this capital may be far
more useful—and therefore valuable—outside of the business
than in it. Returning a portion of the capital ( e.g excess
cash holdings) means curtailing the resources of the enterprise,
perhaps creating financial problems later on and certainly
reducing somewhat the prestige of the officers. Complete liqui¬
dation means the loss of the job itself. It is scarcely to be
expected, therefore, that the paid officers will consider the
question of continuing or winding up the business from the
standpoint solely of what is in the best interests of the owners.
We must emphasize again that the directors are often so closely
allied with the officers—who are themselves members of the
board—that they too cannot be counted upon to consider such
problems purely from the stockholders' point of view.

Thus it appears that the question whether or not a business
should be continued is one that at times may deserve independent
thought by its proprietors, the stockholders. (It should be
pointed out also that this is, by its formal or legal nature, an
ownership problem and not a management problem .) And a logical
reason for devoting thought to this question would arise pre¬
cisely from the fact that the stock has long been selling con¬
siderably below its liquidating value. After all, this situation
must mean that either the market is wrong in its valuation or

600

SECURITY ANALYSIS

the management is wrong in keeping the enterprise alive. It is
altogether proper that the stockholders should seek to determine
which of these is wrong. In this determination the views and
explanations of the management deserve the most appreciative
attention, but the whole proceeding would be stultified if the
management’s opinion on this subject were to be accepted as
final per se .

It is an unhappy fact that in many cases where a management’s
policies are attacked the critic has some personal axe to grind.
This too is perhaps inevitable. There is very little altruism
in finance. Wars against corporate managements take time,
energy and money. It is hardly to be expected that individuals
will expend all these merely to see the right thing done. In
such matters the most impressive and creditable moves are those
made by a group of substantial stockholders, having an important
stake of their own to protect and impelled thereby to act in
the interests of the shareholders generally. Representations
from such a source, in any matter where the interest of the officers
and the owners may conceivably be opposed } should gain a more
respectful hearing from the rank and file of stockholders than
has hitherto been accorded them in most cases. 1

Broadcast criticisms initiated by stockholders, proxy battles,
and various kinds of legal proceedings are exceedingly vexatious
to managements, and in many cases they are unwisely or improp¬
erly motivated. Yet these should be regarded as one of the
drawbacks of being a corporate official and as part of the price
of a vigilant stock ownership. The public must learn to judge
such controversies on their merits, as developed by statements
of fact and by reasoned argument. It must not allow itself
to be swayed by mere accusation or by irrelevant personalities.

The subject of liquidation must not be left without some
reference to the employees’ vital interest therein. It seems
heartless in the extreme to discuss such a decision solely from
the standpoint of what will be best for the stockholder’s pocket-
book. Yet nothing is to be gained by confusing the issue.

1 The proxy regulations of the S.E.C. seek to facilitate the presentation of
viewpoints opposed to the management by requiring the company to send
out requests for proxies (and covering letters) supplied by individual stock¬
holders, postage to be paid by the latter.

BALANCE-SHEET ANALYSIS

601

If the reason for continuing the business is primarily to keep
the workers employed, and if this means a real sacrifice by the
owners, they are entitled to know and to face the fact. They
should not be told that it would be unwise for them to liquidate,
when in truth it would be profitable but inhumane. It is fair
to point out that under our present economic system the owners
of a business are not expected to dissipate their capital for the
sake of continuing employment. In privately owned enterprises
such philanthropy is rare. Whether or not a sacrifice of capital
for this purpose is conducive to the economic welfare of the
country as a whole is a moot point also, but it is not within our
province to discuss it here. Our object has been to clarify the
issue and to stress the fact that a market price below liquidating
value has special significance to the stockholders and should
lead them to ask their management some searching questions.

Management May Properly Take Some Interest in Market
Price for Shares.—Managements have succeeded very well in
avoiding these questions with the aid of the time-honored prin¬
ciple that market prices are no concern or responsibility of theirs.
It is true, of course, that a company's officers are not responsible
for fluctuations in the price of its securities. But this is very
far from saying that market prices should never be a matter of
concern to the management. This idea is not only basically
wrong, but it has the added vice of being thoroughly hypocritical.
It is wrong because the marketability of securities is one of the
chief qualities considered in their purchase. But marketability
must presuppose not only a place where they can be sold but also
an opportunity to sell them at a fair price. It is at least as
important to the stockholders that they be able to obtain a fair
price for their shares as it is that the dividends, earnings and
assets be conserved and increased. It follows that the responsi¬
bility of managements to act in the interest of their shareholders
includes the obligation to prevent—in so far as they are able—the
establishment of either absurdly high or unduly low prices for
their securities.

It is difficult not to lose patience with the sanctimonious
attitude of many corporate executives who profess not even to
know the market price of their securities. In many cases
they have a vital personal interest in these very market prices,

602

SECURITY ANALYSIS

and at times they use their inside knowledge to take advantage
in the market of the outside public and of their own stockholders. 1
Not as a startling innovation but as a common-sense recognition
of things as they are, we recommend that directors be held
to the duty of observing the market price of their securities
and of using all proper efforts to correct patent discrepancies,
in the same way as they would endeavor to remedy any other
corporate condition inimical to the stockholders’ interest.

Various Possible Moves for Correcting Market Prices for
Shares. —The forms that these proper efforts might take are
various. In the first place the stockholders’ attention may be
called officially to the fact that the liquidating, and therefore
the minimum, value of the shares is substantially higher than
the market price. If, as will usually be the case, the directors
are convinced that continuance is preferable to liquidation, the
reasons leading to this conclusion should at the same time be
supplied. A second line of action is in the direction of dividends.
A special endeavor should be made to establish a dividend rate
proportionate at least to the liquidating value, in order that the
stockholders should not suffer a loss of income through keeping
the business alive. This may be done even if current earnings
are insufficient, provided there are accumulated profits and
provided also the cash position is strong enough to permit such
payments.

A third procedure consists of returning to the stockholders
such cash capital as is not needed for the conduct of the business.
This may be done through a pro rata distribution, accompanied
usually by a reduction in par value or through an offer to pur¬
chase a certain number of shares pro rata at a fair price. Finally,
a careful consideration by the directors of the discrepancy
between earning power and liquidating value may lead them

1 This reached such scandalous proportions “in the good old days” that
the Securities Exchange Act of 1934 made “insiders” accountable to the
corporation for profits realized on purchases and sales, or vice versa , com¬
pleted within a six months* period. Enforcement must be through a stock¬
holder’s suit. This provision has been bitterly criticized in Wall Street as
preventing legitimate activities of officers and directors, including support
of the market price at critical times. Our own view is that, on balance, both
logic and practicality are against the provision as it now stands. Publicity
of operations—perhaps immediate rather than monthly—should supply a
sufficient safeguard against fraud and a check upon questionable conduct.

BALANCE-SHEET ANALYSIS

603

to conclude that a sale or winding up of the enterprise is the
most sensible corrective step—in which case they should act
accordingly.

Examples: Otis Company , 1929-1939.—The course of action
followed by the Otis Company management in 1929-1930
combined a number of these remedial moves. In July 1929 the
president circularized the shareholders, presenting an intermedi¬
ate balance sheet as of June 30 and emphasizing the disparity
between the current bid price and the liquidating value. In
September of that year—although earnings were no larger than
before—dividend payments were resumed, a step permitted by
the company’s large cash holdings and substantial surplus. In
1930 a good part of the cash, apparently not needed in the
business, was returned to the stockholders through the redemp¬
tion of the small preferred issue and the repayment of $20 per
share of common stock on account of capital. 1

Subsequently the company embarked on a policy of piecemeal
liquidation which resulted in a series of payments on capital
account. From September 1929 to the final distribution in 1940
there was paid a total of $94 per share as return of capital, as
well as $8 in the form of dividends. As we pointed out in our
last chapter, these steps were highly effective in improving the
status of the Otis stockholders during a period when most other
issues were suffering a shrinkage in value, and ultimately gave
them a far larger return than they were likely to receive through
the continuance of the business.

Hamilton Woolen Company .—The history of this enterprise
since 1926 rs even more interesting in this connection because it
suggests a model technique for the handling by directors of prob¬
lems affecting the stockholders’ investment. In 1927 continued
operating losses had resulted in a market price well below liquidat¬
ing value. There was danger that the losses might continue and
wipe out the capital. On the other hand, there was a possibility
of much better results in the future, especially if new policies
were adopted. A statement of the arguments for and against

1 Other examples of partial return of capital by companies continuing in
business include: Cuban Atlantic Sugar Company (1938-1939), Great
Southern Lumber Company (1927-1937), Keystone Watch Case Corpora¬
tion (1932-1933) as well as Davis Coal and Coke Company and the several
Standard Oil pipe line companies previously referred to (pp. 563, 587).

604

SECURITY ANALYSIS

liquidation was forwarded to the stockholders, and they were
asked to vote on the question. They voted to continue the
business, with a new operating head; and the decision proved a
wise one, since good earnings were realized, and the price
advanced above liquidating value.

In 1934, however, the company again showed a large loss,
occasioned in good part by serious labor difficulties. The man¬
agement again submitted the question of liquidation to the
stockholders, and this time a winding up of the business was
voted. A sale of the business was promptly arranged, and the
stockholders received somewhat more than the November 1934
current-asset value.

Particularly noteworthy were the details of the 1927 proceed¬
ings. The ultimate decision—to continue or to quit—was put
up to the stockholders in whose province it lay; the management
supplied information, expressed its own opinion and permitted
an adequate statement of the other side of the case.

Other Examples of Voluntary Liquidation .—The subjoined
partial list will demonstrate an obvious but fundamental fact,
viz., that the liquidation (or sale) of an unprofitable company

Company

Year liquida¬
tion or sale
voted

Price shortly
before vote to
liquidate
or sell

Amount
realized
for stock

American Glue.

$53

$139.00 +

I. Benesch & Sons.

1939

2 H

6.63

Federal Knitting Milb.

1937

34.20

Lyman Mills.

112

220.25

Mohawk Mining.

28.50

Signature Hosiery Pfd.

3 H

17.00

Standard Oil of Nebraska.

1939

17.50

United Shipyards A .

11.10*

* To Deo. 31. 1939.

holding substantial assets (particularly current) is almost certain
to realize for the stockholders considerably more than the pre¬
viously existing market price. The reason is, of course, that
the market price is governed chiefly by the earnings, whereas the
proceeds of liquidation depend upon the assets.

BALANCE-SHEET ANALYSIS

605

Repurchase of Shares Pro Rata from Shareholders .—The Hamil¬
ton Woolen management is also to be commended for its action
during 1932 and 1933 in employing excess cash capital to repur¬
chase pro rata a substantial number of shares at a reasonable
price. This reversed the procedure followed in 1929 when addi¬
tional shares were offered for subscription to the stockholders.
The contraction in business that accompanied the depression
made this additional capital no longer necessary, and it was there¬
fore a logical move to give most of it back to the stockholders, to
whom it was of greater benefit when in their own pockets than
in the treasury of the corporation. 1

Abuse of Shareholders through Open-market Purchase of
Shares.—During the 1930-1933 depression repurchases of their
own shares were made by many industrial companies out of their
surplus cash assets, 2 but the procedure generally followed was
open to grave objection. The stock was bought in the open
market without notice to the shareholders. This method intro¬
duced a number of unwholesome elements into the situation. It
was thought to be “in the interest of the corporation” to acquire
the stock at the lowest possible price. The consequence of this
idea is that those stockholders who sell their shares back to the
company are made to suffer as large a loss as possible, for the
presumable benefit of those who hold on. Although this is a
proper viewpoint to follow in purchasing other kinds of assets for
the business, there is no warrant in logic or in ethics for applying
it to the acquisition of shares of stock from the company’s own
stockholders. The management is the more obligated to act
fairly toward the sellers because the company is itself on the buy¬
ing side.

1 Hamilton Woolen sold 13,000 shares pro rata to stockholders at $50
per share in 1929. It repurchased, pro rata, 6,500 shares at $65 in 1932 and
1,200 shares at $50 in 1933. Faultless Rubber Company followed a similar
procedure in 1934. Simms Petroleum Company reacquired stock both
directly from the shareholders on a pro rata basis and in the open market.
Its repurchases by both means between 1930 and 1933 aggregated nearly
45% of the shares outstanding at the end of 1929. Julian and Kokenge
(Shoe) Company made pro rata repurchases of common stock in 1932, 1934
and 1939.

2 Figures published by the New York Stock Exchange in February 1934
revealed that 259 corporations with shares listed thereon had reacquired
portions of their own stock.

606

SECURITY ANALYSIS

But, in fact, the desire to buy back shares cheaply may lead to
a determination to reduce or pass the dividend, especially in
times of general uncertainty. Such conduct would be injurious
to nearly all the stockholders, whether they sell or not, and it is
for that reason that we spoke of the repurchase of shares at an
unconscionably low price as only 'presumably to the advantage
of those who retained their interest.

Example: White Motor Company .—In the previous chapter
attention was called to the extraordinary discrepancy between
the market level of White Motor’s stock in 1931-1932 and the
minimum liquidating value of the shares. It will be instructive
to see how the policies followed by the management contributed
mightily to the creation of a state of affairs so unfortunate for
the stockholders.

White Motor Company paid dividends of $4 per share (8%)
practically from its incorporation in 1916 through 1926. This
period included the depression year 1921, in which the company
reported a loss of nearly $5,000,000. It drew, however, upon its
accumulated surplus to maintain the full dividend, a policy
that prevented the price of the shares from declining below
29. With the return of prosperity the quotation advanced to
723^ in 1924 and 1043^ in 1925. In 1926 the stockholders were
offered 200,000 shares at par ($50), increasing the company’s
capital by $10,000,000. A stock dividend of 20% was paid at
the same time.

Hardly had the owners of the business paid in this additional
cash, when the earnings began to shrink, and the dividend was
reduced. In 1928 about $3 were earned (consolidated basis), but
only $1 was disbursed. In the 12 months ending June 30, 1931
the company lost about $2,500,000. The next dividend payment
was omitted entirely, and the price of the stock collapsed to 73^.

The contrast between 1931 and 1921 is striking. In the earlier
year the losses were larger, the profit-and-loss surplus was smaller
and the cash holdings far lower than in 1931. But in 1921 the
dividend was maintained, and the price thereby supported. A
decade later, despite redundant holdings of cash and the presence
of substantial undistributed profits, a single year’s operating
losses sufficed to persuade the management to suspend the
dividend and permit the establishment of a grotesquely low
market price for the shares.

BALANCE-SHEET ANALYSIS

607

During the period before and after the omission of the dividend
the company was active in buying its own shares in the open
market. These purchases began in 1929 under a plan adopted
for the benefit of “those filling certain managerial positions.”
By June 1931 about 100,000 shares had been bought in at a
cost of $2,800,000. With the passing of the dividend, the officers
and employees were relieved of whatever obligations they had
assumed to pay for these shares, and the plan was dropped. In
the next six months, aided by the collapse in the market price,
the company acquired 50,000 additional shares in the market at
an average cost of about $11 per share. The total holdings of
150,000 shares were then retired and cancelled.

These facts, thus briefly stated, illustrate the vicious possibili¬
ties inherent in permitting managements to exercise discretionary
powers to purchase shares with the company's funds. We note
first the painful contrast between the treatment accorded to the
White Motor managerial employees and to its stockholders. An
extraordinarily large amount of stock was bought for the benefit
of these employees at what seemed to be an attractive price. All
the money to carry these shares was supplied by the stockholders.
If the business had improved, the value of the stock would have
advanced greatly, and all the benefits would have gone to the
employees. When things became worse, “those in managerial
positions” were relieved of any loss, and the entire burden fell
upon the stockholders. 1

In its transactions directly with its stockholders , we see White
Motor soliciting $10,000,000 in new capital in 1926. We see
some of this additional capital (not needed to finance sales)
employed to buy back many of these very shares at one-fifth
of the subscription price The passing of the dividend was a
major factor in making possible these repurchases at such low
quotations. The facts just related without further evidence
might well raise a suspicion in the mind of a stockholder that the
omission of the dividend was in some way related to a desire to
depress the price of the shares. If the reason for the passing of
the dividend was a desire to preserve cash, then it is not easy

1 In the sale to Studebaker in 1933 the directors set aside 15,000 shares of
treasury stock as a donation to key men in the organization. Some White
stockholders brought suit to set aside this donation, and the suit was settled
by payment of 31 cents per share on White stock not acquired by Studebaker.

608

SECURITY ANALYSIS

to see why, since there was money available to buy in stock, there
was not money available to continue a dividend previously paid
without interruption for 15 years.

The spectacle of a company overrich in cash passing its divi¬
dend, in order to impel desperate stockholders to sell out at a
ruinous price, is not pleasant to contemplate.

Westmoreland Coal Company: Another Example .—A more
recent illustration of the dubious advantage accruing to stock¬
holders from a policy of open-market repurchases of common
stock is supplied by the case of Westmoreland Coal. In the
ten years 1929-1938 this company reported a net loss in the
aggregate amounting to $309,000, or $1.70 per share. However,
these losses resulted after deduction of depreciation and deple¬
tion allowances totaling $2,658,000, which was largely in excess
of new capital expenditures. Thus the company’s cash position
actually improved considerably during this period, despite pay¬
ment of very irregular dividends aggregating $4.10 per share.

In 1935, according to its annual reports, the company began
to repurchase its own stock in the open market. By the end of
1938 it had thus acquired 44,634 shares, which were more than
22% of the entire issue. The average price paid for this stock
was $8.67 per share. Note here the extraordinary fact that this
average price paid was less than one-half the cash-asset holdings
alone per share, without counting the very large other tangible
assets. Note also that at no time between 1930 and 1939 did
the stock sell so high as its cash assets alone. (At the end of
1938 the company reported cash and marketable securities
totaling $2,772,000, while the entire stock issue was selling for
$1,400,000.)

If this situation is analyzed, the following facts appear clear:

1. The low market price of the stock was due to the absence of earnings
and the irregular dividend. Under such conditions the quoted price would
not reflect the very large cash holding theoretically available for the shares.
Stocks sell on earnings and dividends and not on cash-asset values—unless
distribution of these cash assets is in prospect.

2. The true obligation of managements is to recognize the realities of
such a situation and to do all in their power to protect every stockholder
against unwarranted depreciation of his investment, and particularly
against unnecessary sacrifice of a large part of the true value of his shares.
Such sacrifices are likely to be widespread under conditions of this kind,
because many stockholders will be moved by necessity or the desire for

BALANCE-SHEET ANALYSIS 609

steady income or by a discouraged view of the coal industry to sell their
shares for what they can get.

3. The anomaly presented by exceptionally large cash holdings and an
absurdly low market price was obviously preventable. That the company
had more cash than it needed is confessed by the fact that it had money
available to buy in cheap stock—even if it were not evident from a study of
the unusual relationship between cash holdings and annual business done.

4 . All cash that could possibly be spared should have been returned to the
stockholders on a pro rata basis. The use of some of it to buy in shares as
cheaply as possible is unjust to the many stockholders induced by need or
ignorance to sell. It favors those strong enough to hold their shares
indefinitely. It particularly advantages those in control of the company,
for in their case the company's cash applicable to their stock is readily
available to them if they should need it (since they could then bring about a
distribution). Just because this situation is distinctly not true of the rank
and file of the stockholders, the market discounts so cruelly the value of
their cash when held by the company instead of themselves. 1

Summary and Conclusion. —The relationship between stock¬
holders and their managements, after undergoing many unsound
developments during the hectic years from 1928 to 1933, have
since been subjected to salutary controls—emanating both from
S.E.C. regulation and from a more critical viewpoint generally.
Certain elementary facts, once well-nigh forgotten, might well
be emphasized here: Corporations are in law the mere creatures
and property of the stockholders who own them; the officers
are only the paid employees of the stockholders; the directors,
however chosen, are virtually trustees, whose legal duty it is
to act solely in behalf of the owners of the business. 2

1 Two additional factors in this situation deserve brief mention. The
company had a rental obligation of 10 cents per ton, but not less than
$189,000 annually, for mining coal from leased lands. This liability was an
additional consideration, besides the ordinary ones, which argued for
maintenance of a comfortable cash position, but it could not justify the
immobilizing of far more cash than the whole company appeared to be
worth at any time between 1930 and 1939.

In October 1939 the company made application to the S.E.C. to termi¬
nate trading in its shares on the Philadelphia Stock Exchange and the New
York Curb Exchange, intimating that the infrequency of transactions might
be responsible for their unduly low price. The reader may judge whether
or not, in the circumstances, the plight of the stockholders would be relieved
in any wise by destroying the established market for their shares. (The
application was later withdrawn.)

* The management of American Telephone and Telegraph Company
hmm. repeatedly asserted that it considers itself a trustee for the interests of

610

SECURITY ANALYSIS

To make these general truths more effective in practice, it is
necessary that the stock-owning public be educated to a clearer
idea of what are the true interests of the stockholders in such
matters as dividend policies, expansion policies, the use of corpo¬
rate cash to repurchase shares, the various methods of com¬
pensating management, and the fundamental question of whether
the owners’ capital shall remain in the business or be taken
out by them in whole or in part.

stockholders, employees and the public, in equal measure. A policy of this
kind, if frankly announced and sincerely followed, can scarcely be criticized
in the case of a quasi-civic enterprise. But given the ordinary business
company, the issue is more likely to be whether the management is acting
as trustees for the stockholders or as trustees for the management.

CHAPTER XLV

BALANCE-SHEET ANALYSIS (( Concluded )

Our discussion in the preceding chapters has related chiefly
to situations in which the balance-sheet exhibit apparently
justified a higher price than prevailed in the market. But the
more usual purpose of balance-sheet analysis is to detect the
opposite state of affairs, viz., the presence of financial weaknesses
that may detract from the investment or speculative merits
of an issue. Careful buyers of securities scrutinize the balance
sheet to see if the cash is adequate, if the current assets bear a
suitable ratio to the current liabilities, and if there is any indebt¬
edness of near maturity that may threaten to develop into a
refinancing problem.

WORKING-CAPITAL POSITION AND DEBT MATURITIES

Basic Rules Concerning Working Capital.—Nothing useful may
be said here on the subject of how much cash a corporation should
hold. The investor must form his own opinion as to what is
needed in any particular case and also as to how seriously an
apparent deficiency of cash should be regarded. On the subject
of the working-capital ratio , a minimum of $2 of current assets for
$1 of current liabilities was formerly regarded as a standard for
industrial companies.

But since the late 1920's a tendency towards a stronger current
position developed in most industries, and we find that the great
majority of industrial corporations show a ratio well in excess of
2 to l. 1 There is some tendency now to hold that a company
falling below the average of its group should be viewed with
suspicion. 2 This idea seems to us to contain something of a

1 See Appendix Note 61, p. 790, for comprehensive data with reference to
industrial corporations listed on the New York Stock Exchanges at the end
of 1938. See also the annual compilations in Moody*s Manual of Industrials.

1 See Roy A. Foulke, Signs of the Times , pp. 17-19, 25 et seq., New York,
1938; and Alexander Wall, How to Evaluate Financial Statements , pp. 82-97,
New York, 1936. Note, however, Wall's criticism of mere arithmetical
averages as bases for comparison.

611

612

SECURITY ANALYSIS

logical fallacy, since it necessarily penalizes the lower half of any
group, regardless of how satisfactory the showing may be, con¬
sidered by itself. We are unable to suggest a better figure than
the old 2-to-l criterion to use as a definite quantitative test of
a sufficiently comfortable financial position. Naturally the
investor would favor companies that well exceed this minimum
requirement, but the problem is whether or not a higher ratio
must be exacted as a condition for purchase, so that an issue
otherwise satisfactory would necessarily be rejected if the
current assets are only twice current liabilities. We hesitate
to suggest such a rule, nor do we know what new figure to
prescribe.

A second measure of financial strength is the so-called “acid
test,” which requires that current assets exclusive of inventories
be at least equal to current liabilities. Ordinarily the investor
might well expect of a company that it meet both the 2-to-l test
and the acid test. If neither of these criteria is met it would
in most cases reflect strongly upon the investment standing of a
common-stock issue—as it would in the case of a bond or pre¬
ferred stock—and it would supply an argument against the
security from the speculative standpoint as well.

Archer-Daniels-Midland Company

Item

June 30,
1933

June 30,
1932

Cash assets.

3 1,392,000
4,391,000
12,184,000

$3,230,000

2,279,000

4,081,000

Receivables.;.

Inventories.

Total current assets.

$17,967,000

8,387,000

$9,690,000

778,000

Current liabilities.

Working capital.

$ 9,580,000
-2,604,000

$8,812,000

+4,731,000

Working capital excluding inventories. .

Exceptions and Examples .—As in all arbitrary rules of this kind,
exceptions must be allowed if justified by special circumstances.
Consider, for example, the current position of Archer-Daniels-
Midland Company on June 30, 1933, as compared with the
previous year’s figures.

BALANCE-SHEET ANALYSIS

613

The position of this company on June 30, 1933, was evidently
much less comfortable than a year before, and, judged by the
usual standards, it might appear somewhat overextended. But
in this case the increase in payables represented a return to the
normal practice in the vegetable-oil industry, under which fairly
large seasonal borrowings are regularly incurred to carry grain
and flaxseed supplies. Upon investigation, therefore, the
analyst would not consider the financial condition shown in the
1933 balance sheet as in any sense disturbing.

Contrasting examples on this point are supplied by Douglas
Aircraft Company and Stokely Brothers and Company in
1936-1938.

A Working-Capital Comparison
(000 omitted)

Item

Stokely Brothers and Company

Douglas Aircraft
Company

May 31,

Nov. 30,

1936

1937

1938

1936

1937

1938

Current assets:

Cash and receivables. . . .

$2,274

$2,176

$1,827

$2,885

$ 2,559

$4,673

Inventories .

5,282

7,323

6,034

6,392

12,240

4,084

Total .

$7,556

$9,499

$8,861

$9,277

$14,749

$8,757

Current liabilities:

Notes payable ....

$2,000

$2,500

$1,390

$ 5,230

Other.

1,527

1,286

1,320

1,179

3,183

$2,129

Total .

$3,527

$3,286

$3,820

$2,569

$ 8,413

$2,129

Bank loans due 1-3 years .

3,000

Total current liabilities

plus 1-3 year notes

3,527

6,286

6,820

2,569

8,413

2,129

Net earnings for year .

1,382

S5S(d)

715(d)

976

1,082

2,117

The situation in Douglas Aircraft in 1937 was not a seasonal
matter, as in the case of Archer-Daniels-Midland, but grew out of
the receipt of certain types of orders requiring considerable work¬
ing capital. Upon inquiry the investor could have satisfied
himself that the need for bank accommodation was likely to be
temporary and that, in any event, the new business was suffici¬
ently profitable to make any necessary financing an easy affair.
The Stokely picture was quite different, since the large current
debt had developed out of expanding inventories in an unprofit-

614

SECURITY ANALYSIS

able market. Hence the May 1937 balance sheet of Stokely
carried a serious warning for the preferred and common stock¬
holder, as the table shows.

A year later Douglas Aircraft had paid off its bank loans and
showed a current ratio of 4 to 1. Stokely suspended preferred
dividends in October 1938, and in that year the price of the issue
fell from 21 (par $25) to 10.

As we pointed out in our discussion of bond selection (Chap.
XIII), no standard requirements such as we have been discussing
are recognized as applicable to railroads and public utilities.
It must not be inferred therefrom that the working-capital
exhibit of these companies is entirely unimportant—the contrary
will soon be shown to be true—but only that it is not to be tested
by any cut-and-dried formulas.

Large Bank Debt Frequently a Sign of Weakness. —Financial
difficulties are almost always heralded by the presence of bank
loans or of other debt due in a short time. In other words, it is
rare for a weak financial position to be created solely by ordinary
trade accounts payable. This does not mean that bank debt is a
bad sign in itself; the use of a reasonable amount of bank credit
—particularly for seasonal needs—is not only legitimate but even
desirable. But, whenever the statement shows Notes or Bills
Payable, the analyst will subject the financial picture to a some¬
what closer scrutiny than in cases where there is a “clean”
balance sheet.

The postwar boom in 1919 was marked by an enormous
expansion of industrial inventories carried at high prices and
financed largely by bank loans. The 1920-1921 collapse of
commodity prices made these industrial bank loans a major
problem. But the depression of the 1930's had different charac¬
teristics. Industrial borrowings in 1929 had been remarkably
small, due first to the absence of commodity or inventory specula¬
tion and secondly to the huge sales of stock to provide additional
working capital. (Naturally there were exceptions, such as,
notably, Anaconda Copper Mining Company which owed
$35,000,000 to banks at the end of 1929, increased to $70,500,000
three years later.) The large bank borrowings were shown more
frequently by the railroads and public utilities. These were
contracted to pay for property additions or to meet maturing
debt or—in the case of some railways—to carry unearned fixed

BALANCE-SHEET ANALYSIS

615

charges. The expectation in all these cases was that the bank
loans would be refunded by permanent financing; but in many
instances such refinancing proved impossible, and receivership
resulted. The collapse of the .Insull system of public-utility
holding companies was precipitated in this way.

Examples: It is difficult to say exactly how apprehensively the
investor or speculator should have viewed the presence of $68,-
000,000 of bank loans in the New York Central balance sheet at
the end of 1932 or the bills payable of $69,000,000 owed by
Cities Service Company on December 31, 1931. But certainly
this adverse sign should not have been ignored. The more
conservatively minded would have taken it as a strong argument
against any and all securities of companies in such a position,
except possibly issues selling at so low a price as to constitute an
admitted but attractive gamble. An improvement in conditions
will, of course, permit such bank loans to be refunded, but logic
requires us to recognize that the improvement is prospective
whereas the bank loans themselves are very real and very
menacing. 1

When a company’s earnings are substantial, it rarely becomes
insolvent because of bank loans. But if refinancing is impracti¬
cable—as frequently it was in the 1931-1933 period—the lenders
may require suspension of dividends in order to make all the
profits available to reduce the debt. It is for this reason that
the dividend on Brooklyn-Manliattan Transit Corporation com¬
mon was passed in 1932 and the preferred dividend of New
York Water Service Corporation was passed in 1931, although
both companies were reporting earnings about as large as in
previous years.

The 1937-1938 recession did not create corporate financial
problems comparable with those arising out of the two previous
depressions. In this respect there is a significant contrast
between the stock markets of 1919-1921 and 1937-1938. For
the decline in stock prices was actually greater—both in dollars
and percentagewise—in the recent period than in the postwar
collapse, although intrinsically the 1937-1938 downturn was of
much smaller importance, since it had relatively slight effect

1 Improvement in general business, plus easy money rates (plus in the
case of railroads a misguided optimism on the part of investors) enabled
many companies to fund bank loans that looked dangerous in 1931—1933.

616

SECURITY ANALYSIS

upon the position of American corporations generally. 1 This
may be taken as a rather disquieting sign that stock prices have
been growing more irrationally sensitive to temporary fluctua¬
tions in business—a fact that we are inclined to ascribe to the
disappearance of the old-line distinctions between stock investors
and stock speculators.

Intercorporate Indebtedness.—Current debt to a parent or
to an affiliated company is theoretically as serious as any other
short-term liability, but in practice it is rarely made the basis
of an embarrassing claim for payment.

Example: United Gas Corporation has owed $26,000,000 on
open account to its parent Electric Bond and Share Company
since 1930—so that it constantly reports a large excess of current
liabilities over current assets. Yet this debt has not prevented
it from paying first preferred dividends in 1936-1939. In 1932,
however, with somewhat larger earnings than in 1939, it had been
compelled to suspend the senior dividend because it had large
bank loans in addition to its intercompany debt. The conserva¬
tive buyer would naturally prefer to see the obligations to affili¬
ates in some form other than a current liability.

The Danger of Early Maturing Funded Debt.—A large bond
issue coming due in a short time constitutes a critical financial
problem when operating results are unfavorable. Investors
and speculators should both give serious thought to such a
situation when revealed by a balance sheet. Maturing funded
debt is a frequent cause of insolvency.

Examples: Fisk Rubber Company was thrown into receivership
by its inability to pay off an $8,000,000 note issue at the end of
1930. The insolvency of Colorado Fuel and Iron Company and
of the Chicago, Rock Island and Pacific Railway Company in
1933 were both closely related to the fact that large bond issues
fell due in 1934. The heedlessness of speculators is well shown
by the price of $54 established for Colorado Fuel and Iron
Preferred in June 1933, when its short-term bond issue (Colorado
Industrial Company 5s, due 1934, guaranteed by the parent
company) was selling at 45, an indicated yield of well over 100%
per annum . This price for the bonds was an almost certain sign
of trouble ahead. Failure to meet the maturity would in all

1 The Stokely case is an exception to this statement, but there were
surprisingly few of the kind.

BALANCE-SHEET ANALYSIS

617

likelihood mean insolvency (for a voluntary extension could by
no means be counted upon) and the danger of complete extinction
of the stock issues. It was typical of the speculator to ignore
so obvious a hazard and typical also that he suffered a large loss
for his carelessness. (Two months later, on announcement of the
receivership, the price of the preferred stock dropped to 17%.)

New York, Chicago and St. Louis Railroad Company has been
faced with a continuous financial problem growing out of the sale
of a three-year note issue in 1929. Since the first maturity
in 1932 it was repeatedly extended under threat of receivership
as an alternative. Typical of speculative disregard of financial
problems was the advance of this company’s preferred stock
from 18% to 45% in 1939, against a low price that year of only
50 for the notes due in 1941.

Even when the maturing debt can probably be taken care of in
some way, the possible cost of the refinancing must be taken into
account.

Examples: This point is well illustrated by the $14,000,000 issue
of American Rolling Mill Company 4%% Notes, due November
1, 1933. In June 1933 the notes were selling at 80, which meant
an annual yield basis of about 75%. At the same time the
common stock had advanced from 3 to 24 and then represented
a total valuation for the common stock of over $40,000,000.
Speculators buying the stock because of improvement in the steel
industry failed to consider the fact that, in order to refund the
notes in the poor market then existing for new capital issues, a
very attractive conversion privilege would have to be offered.
This would necessarily react against the profit possibilities of
the common stock. As it happened, a new 5% note issue,
convertible into stock at 25, was offered in exchange for the 4%%
notes. The result was the establishment of a price of 101 for
the notes in August 1933 against a coincident price of 21 for
the common stock; and a price of 15 for the stock on November
1, 1933, when the notes were taken care of at par.

The impending maturity of a bond issue is of importance to
the holders of all the company’s securities, including mortgage
debt ranking ahead of the maturing issue. For even the prior
bonds will in all likelihood be seriously afiected if the company
is unable to take care of the junior issue. This point is illustrated
in striking fashion by the Fisk Rubber Company First Mortgage

618

SECURITY ANALYSIS

8s, due 1941. Although they were deemed to be superior in their
position to the 53^% unsecured notes, their holders suffered
grievously from the receivership occasioned by the maturity of
the 53^s. The price of the 8s declined from 115 in 1929 to 16
in 1932. 1

Bank Loans of Intermediate Maturity.—The combination of
very low interest rates and the drying up of ordinary commercial
bank loans has produced a new phenomenon in recent years—
the loaning of money to corporations by banks, repayable over
a period of several years. Most of this money has been borrowed
for the purpose of retiring bond issues ( e.g ., Commercial Invest¬
ment Trust Corporation in November 1939) and even preferred
stock (e.g., Archer-Daniels-Midland Company in 1939). In
some cases such loans have been made for additional working
capital (e.g., Western Auto Supply Company in 1937) or to
replace ordinary short-term bank credit (e.g., American Com¬
mercial Alcohol, Stokely Brothers). In most cases it is stipu¬
lated or expected that the loans will be retired in annual
installments.

From the standpoint of security analysis this bank credit
resembles the short-term notes that used to be sold to the public
as a familiar part of corporate financing. It must be considered
partly equivalent to current liabilities and partly to early matur¬
ing debt. It is not dangerous if either the current-asset position
is so strong that the loans could readily be taken care of as
current liabilities or the earning power is so large and dependable
as to make refinancing a simple problem. But if neither of these
conditions is present (as in the Stokely example on page 613),
the analyst must view the presence of a substantial amount of
intermediate bank debt as a potential threat to dividends or
even to solvency.

It should not be necessary to dilate further upon the prime
necessity of examining the balance sheet for any possible adverse
features in the nature of bank loans or other short term debt.

COMPARISON OF BALANCE SHEETS OVER A PERIOD OF TIME

This important part of security analysis may be considered
under three aspects, viz.:

1 See other references to the two Fisk bond issues in Chaps. VI, XVIII,
and L.

BALANCE-SHEET ANALYSIS

619

1. As a check-up on the reported earnings per share.

2. To determine the effect of losses (or profits) on the financial position
of the company.

3. To trace the relationship between the company’s resources and its
earning power over a long period.

Check-up on Reported Earnings per Share, Via the Balance
Sheet.—Some of this technique has already been used in connec¬
tion with related phases of security analysis. In Chap. XXXVI,
for instance, we gave an example of the first aspect, in checking
the reported earnings of American Commercial Alcohol Corpora¬
tion for 1931 and 1932. As an example covering a larger stretch
of years we submit the following contrast between the average
earnings of United States Industrial Alcohol Company for the
ten years 1929-1938, as shown by the reported per-share figures
and as indicated by the changes in its net worth in the balance
sheet.

U. S. Industrial Alcohol Company, 1929-1938
1. net earnings as reported

1929

84,721,000

*Pcr share: $12 63

1930

1,105,000

2 95

1931

1,834,000(d)

4 oo(d)

1932

176,000

0 47

1933

1,393,000

3 56

1934

1,580,000

4 03

1935

844,000

2 15

1936

78,000

0 20

1937

456,000(d)

1.17(d)

1938

668,000(d)

1 71(d)

Total for 10 years .

$6,782,000

$18.21

* As stated in the company’s annual reports.

2. DISCREPANCY BETWEEN EARNINGS AS ABOVE AND CHANGES IN TIIE SURPLUS

ACCOUNT

Net earnings 1929-1938, as reported. • • $ 6,782,000

Less dividends paid. • • 5,959,000

(A) Indicated balance to surplus. 823,000

Earned surplus Dec. 31, 1928. 14,214,000

Less charge @ write-down of plant account to $1 in 1933 455,000

Earned surplus Dec. 31, 1928, as adjusted. 13,759,000

Earned surplus and contingency reserve, Dec. 31, 1938 . _5, 736,000

(£) Decrease in surplus on balance sheet. 8,023,000

Discrepancy between earnings shown in income accounts

and those indicated by balance sheets. $ 8,846,000

620

SECURITY ANALYSIS

3. EXPLANATION OP DISCREPANCY

Charges made to surplus and not deducted in income account from which
earnings per share were computed by company:

Mark-down of inventory. $4,500,000

Charge-off and write-down of various assets. 3,969,000

Miscellaneous adjustments, net. 377,000

$8,846,000

In addition to the foregoing the company wrote down its fixed
assets to $1 in 1933 by a charge of $19,301,000, of which $18,846,-
000 was taken out of capital account and the balance out of
surplus. To the extent that depreciation charges since 1932
may have been insufficient because of this write-down (see
p. 489), the reported earnings for the period were further
overstated.

4. RESTATEMENT OF EARNINGS FOR 1929-1938

Earnings per income account. $6,782,000

Less charges made to surplus. 8,846,000

Earnings for period as corrected. $2,064,000(d)

5. WORKING CAPITAL COMPARISON! 1938 VS. 1928

Net working capital Dec. 31, 1928. $11,336,000

Net working capital Dec. 31, 1938. 8,144,000

Decrease for ten years. 3,192,000

Add proceeds of sales of capital stock. 6,582,000

Real shrinkage in working capital for period... $ 9,774,000

The foregoing analysis does not require extended discussion,
since most of the points involved were covered in Chaps. XXXI
to XXXVI. Virtually all the charges made to surplus between
1929 and 1938 (except for the write-down of the plant account
to $1) represented a real diminution of the reported earning
power of United States Industrial Alcohol during this ten-year
period. It seems likely, also, that the surplus would have shrunk
considerably farther if the plant account had been carried at a
proper figure and appropriate depreciation charged against it
since 1932. The fact that the company’s working capital
decreased by $3,192,000, despite receipt of $6,582,000 from the
sale of additional stock, is further evidence that, instead of there
being a surplus above dividends as reported, the company
actually lost money before dividends during these ten years. 1

1 An analysis of the exhibit of Stewart Warner Corporation for 1925-1932,
leading to similar conclusions, appeared at this point in our 1934 edition.
Cf, W. A. Hosmer, “The Effect of Direct Charges to Surplus on the Measure-

BALANCE-SHEET ANALYSIS

621

Checking the Effect of Losses or Profits on the Financial
Position of the Company, —An example of the second aspect
was given in Chap. XLIII, in the comparison of the 1929-1932
balance sheets of Manhattan Shirt Company and Hupp Motor
Car Corporation respectively. A similar comparison is appended
herewith, covering the exhibit of Plymouth Cordage Company
and H. R. Mallinson and Company during the same period,
1929-1932.

Examples:

Item

Plymouth
Cordage Co.

H. R. Mallin¬
son & Co.

Earnings reported:

1930.

$ 288,000
25,000
233,000(d)

$1,467,000(d)
661,000(d)
200,000(d)

1931.

1932.

Total (3 years) profit.

$ 80,000
1,348,000
2,733,000

§2,218,000(d)
66,000
116,000

Dividends.

Charges to surplus and reserves... .

Decrease in surplus and reserve for
3 vears.

S4.001.000

$2,400,000

ment of Income,” Business and Modern Society, ed. by M. P. McNair and
H. T. Lewis, pp. 113-151, Harvard University Press, 1938.

622

SECURITY ANALYSIS

Comparative Balance Sheets
(000 omitted)

Plymouth Cordage

H. R. Mallinson

Item

Sept. 30,
1929

Sept. 30,
1932

Dec. 31,
1929

Dec. 31,
1932

Fixed and miscellaneous assets

(net).

$ 7,211

$ 5,157

$2,539

$2,224

Cash assets.

1,721

3,784

526

Receivables.

1,156

668

1,177

Inventories.

8,059

621

Total assets.

$18,147

$12,759

$7,302

$3,035

Current liabilities.

Preferred stock.

$ 982

$ 309

$2,292

1.342

$ 486*
1,281

500

Common stock.

8,108

7,394

Surplus and miscellaneous reserves

3,168

768

Total liabilities.

$18,147

$12,759

$3,035

Net current assets.

Net current assets excluding

$ 9,954

$ 7,298

$2,471

$ 357

inventory.

1,895

4,143

580(d)

264(d)

* Including $32,000 of "defeired liabilities.”

Despite the large reduction in the surplus of Plymouth Cordage
during these years, its financial position was even stronger at the
end of the period than at the beginning, and the liquidating value
per share (as distinct from book value) was probably somewhat
higher. On the other hand, the losses of Mallinson almost
denuded it of working capital and thereby created an extremely
serious obstacle to a restoration of its former earning power.

Taking Losses on Inventories May Strengthen Financial Position .
It is obvious that losses that are represented solely by a decline
in the inventory account are not so serious as those which must
be financed by an increase in current liabilities. If the shrinkage
in the inventory exceeds the losses, so that there is an actual
increase in cash or reduction in payables, it may then be proper
to say—somewhat paradoxically—that the company's financial
position has been strengthened even though it has been suffering
losses. This reasoning has a concrete application in analyzing

BALANCE-SHEET ANALYSIS

623

issues selling at less than liquidating value. It will be recalled
that, in estimating break-up value, inventories are ordinarily
taken at about 50 to 75 % of the balance sheet figure, even though
the latter is based on the lower of cost or market. The result
is that what appears as an operating loss in the company’s
statement may have the actual effect of a profit from the stand¬
point of the investor who has valued the inventory in his own
mind at considerably less than the book figure. This idea is
concretely illustrated in the Manhattan Shirt Company example.

Manhattan Shirt Company
(000 omitted)

Item

Balance sheet
Nov. 30, 1929

Balance sheet
Nov. 30, 1932

Book

value

Estimated
liquidat¬
ing value

Book

value

Estimated
liquidat¬
ing value

Cash and bonds at market.

Receivables.

Inventories.

Fixed and other assets.

Total assets.

Current liabilities.

Preferred stock.

Balance for common .

Number of shares.

Value per share.

$ 885

2,621
4,330
2,065*

$ 1,961
771
1,289
1,124

$ 9,901
2,574
299

$ 6,385
2,574
299

$ 5,145
100

$ 7,028
281,000
$25.00

|||

♦ Excluding good-will.

INCOME ACCOUNT 1930-1932

Balance after preferred dividends:

1930 ... 818,000(d)

1931 . 93,000

1932 . 139,000(d)

3 years . 864,000(d)

Charges to surplus. 505,000*

Common dividends paid. 723,000

$1,592,000

Less discount on common stock bought 481,000

Decrease in surplus for period. . . $1,111,000*

* Eliminating transfer of $100,000 to Contingency React ve.

624

SECURITY ANALYSIS

If we consider only the company’s figures there was evidently
a loss for the period, with a consequent shrinkage in the value
of the common stock. But if an investor had bought the stock,
say, at $8 per share in 1930 (the low price in that year was 6%),
he would more logically have appraised the stock in his own mind
on the basis of its liquidating value rather than its book value.
From his point of view, therefore, the intrinsic value of his hold¬
ings would have increased during the depression period from
$12.50 to $14.75 per share, even after deducting the substantial
dividends paid. What really happened was that Manhattan
Shirt turned the larger portion of its assets into cash during these
three years and sustained a much smaller loss in so doing than a
conservative buyer of the stock would have anticipated. This
accomplishment can be summarized as follows, in approximate
figures:

Assets turned into cash and
application of proceeds

Amount

“Expected loss” thereon and
application of difference

Reduction in inventory.

$3,000,000

$1,000,000

Reduction in receivables.

1,800,000

350,000

Reduction in plant, etc.

1,000,000

750,000

Actual loss sustained.

$5,800,000

800,000

$2,100,000

800,000

Net amount realized.

$5,000,000

“Gain” on basis of

Applied as follows:

To common dividends....

$ 700,000

liquidation values $1,300,000
Applied as follows:

To common

To payment of liabilities..

2,500,000

dividends... $ 700,000
To increase

300,000

500,000

1,000,000

$5,000,000

liquidating

value. $ 600,000

We have here a direct contrast between the superficial indica¬
tions of the income account and the truer story told by the
successive balance sheets. Situations of this kind justify our

BALANCE-SHEET ANALYSIS

625

repeated assertion that income-account analysis must be supple¬
mented and confirmed by balance-sheet analysis. 1

Is Shrinkage in Value of Normal Inventory an Operating Losst —
A further question may be raised with respect to changes in the
inventory account, i.e., whether or not a mere reduction in the
carrying price should be regarded as creating an operating loss.
In the case of Plymouth Cordage we note the following compara¬
tive figures:

Inventory Sept. 30, 1929. $8,059,000

Inventory Sept. 30, 1932. 3,150,000

Decrease. 60 %

In the meantime the price of fibers had declined more than
50%, and there was good reason to believe that the actual
number of pounds of fiber, rope and twine contained in the
company^ inventory was not very much smaller in 1932 than in
1929. At least half of the decline in the inventory account was
therefore due solely to the fall in unit prices. Did this portion
of the shrinkage in inventory values constitute an operating loss?
Could it not be argued that its fixed assets had suffered a similar
reduction in their appraisal value and that there was as much
reason to charge this shrinkage against earnings as to charge
the shrinkage in the carrying price of a certain physical amount
of inventory?

We have already discussed this point in our exposition of the
“normal-stock 77 basis of inventory valuation (in Chap. XXXII),
a method adopted by Plymouth Cordage itself after 1932. In
theory the analyst might attempt to put all companies on a
normal-stock basis for the purpose of calculating their earning
power exclusive of inventory fluctuations and for uniform com¬
parisons. Actually, he has not the data necessary for such
calculations. Hence he is reduced—here, as in many fields of
analysis—to the necessity of making general rather than exact
allowance for the distorting effect of inventory price changes.

Profits from Inventory Inflation. —That the importance of
inventory price changes is not confined to a depression period is
emphatically shown by the events of 1919 and 1920. In 1919
the profits of industrial companies were very large; in 1920 the
reported earnings were irregular but in the aggregate quite

1 The student will note a similar development in Manhattan Shirt, though
on a smaller scale, between December 1937 and December 1938.

626

SECURITY ANALYSIS

substantial. Yet the gains shown in these two years were in
many cases the result of an inventory inflation , i.e., a huge and
speculative advance in commodity prices. Not only was the
authenticity of these profits thereby made open to question, but
the situation was replete with danger because of the large bank
loans contracted to finance these overvalued inventories.

Examples: The following tabulation, which covers a number of
the leading industrial companies, will bring out the significant
contrast between the apparently satisfactory earnings develop¬
ments and the undoubtedly disquieting balance-sheet develop¬
ments between the end of 1918 and the end of 1920.

Twelve Industrial Companies (Aggregate Figures)

Year 1919 Year 1920 Years 1919-1920

Earned for common Btock.

$100,000,000

$ 48,000,000

$148,000,000

Dividends paid.

35,000,000

68,000,000

103,000,000

Charges to surplus.

5,000,000

10,000,000

15,000,000

Added to surplus.

60,000,000

SO,000,000 (deer.)

30,000,000

Inventories increased.

67,000,000

84,000,000

141,000,000

Change in other net current assets.

+30,000,000

131 , 000,000 (deer.)

101 ,000,000 (deer.)

Plant, etc. increased.

33,000,000

169,000,000

202,000,000

Capitalization increased.

69,000,000

141,000,000

210,000,000

Reserves increased.

12,000,000

The companies included in the foregoing computation were
American Can, American Smelting and Refining, American
Woolen, Baldwin Locomotive Works, Central Leather, Corn
Products Refining, General Electric, B. F. Goodrich, Lackawanna
Steel, Republic Iron and Steel, Studebakcr, United States
Rubber.

We append also the individual figures for United States
Rubber, in order to add concreteness to our illustration:

U. S. Rubber (1919-1920)

Earned for common stock:

1919 . $12,670,000 Per share: $17.60

1920 . 16,002,000 19.76

Total. $28,672,000 $37.36

Cash dividends paid. 8,580,000

Stock dividend paid. 9,000,000

Transferred to contingency reserve. 6,000,000

Adjustments of surplus and reserves .. . c r. 2,210,000
Net increase in surplus and miscellane¬
ous reserves.

$7,300,000

BALANCE-SHEET ANALYSIS

627

Balance Sheet
(000 omitted)

Item

Dec. 31,
1918

Dec. 31,
1920

Increase

Plant and miscellaneous assets (net)...

$131,000

$185,500

$ 54,600

Inventories.

70,700

123,500

52,800

Cash and receivables. • ...

49,500

63,600

14,100

Total assets.

$251,200

$372,600

$121,400

Current liabilities.

$ 26,500

$ 74,300

$ 47,800

Bonds.

68,600

87,000

18,400

Preferred and common stock.

98,400

146,300

49,900

Surplus and miscellaneous reserves.

57,700

65,000

7,300

Total liabilities.

$251,200

$372,600

$121,400

Working capital.

93,700

112,800

19,100

Working capital excluding inventory...

23,000

10,700(d)

33,700(d)

The United States Rubber figures for 1910-1920 present the
complete reverse of Manhattan Shirt’s exhibit for 1930-1932.
In the Rubber example we have large earnings but a coincident
deterioration of the financial position due to heavy expenditures
on plant and a dangerous expansion of inventory. The stock
buyer would have been led astray completely had he confined his
attention solely to United States Rubber’s reported earnings of
nearly $20 per share in 1920; and, conversely, the securities
markets were equally mistaken in considering only the losses
reported during 1930-1932, without reference to the favorable
changes occurring at the same time in the balance-sheet position
of many companies.

It will be noted from our discussion here and in Chap. XXXII
that the matter of inventory profits or losses belongs almost
equally in the field of income account and of balance-sheet
analysis.

Long-range Study of Earning Power and Resources. —The

third aspect of the comparison of successive balance sheets is of
restricted interest because it comes into play only in an exhaustive
study of a company’s record and inherent characteristics. The
purpose of this kind of analysis may best be conveyed by means

628

SECURITY ANALYSIS

of the following applications to the long-term exhibits of United
States Steel Corporation and Corn Products Refining Company.

I. United States Steel Corporation: Analysis of
Operating Results and Financial Changes by
Decades, 1903-1932 1

The balance sheets are adjusted to exclude an intangible item
(“water”), amounting to $508,000,000, originally added to the
Fixed Property Account. This was subsequently written off
between 1902 and 1929 by means of an annual sinking-fund
charge (aggregating $182,000,000) and by special appropriations
from surplus. The sinking-fund charges in question are also
eliminated from the income account.

A . Operating Results
(In millions)

Item

First

decade

1903-1912

Second

decade

1913-1922

Third

decado

1923-1932

Total
for 30
years

Finished goods produced.

Gross sales (excluding inter-

93.4 tons

123.3 tons

118.7 tons

335.4 tons

company items).

$4,583

89,185

$22,968

Net earnings*.

979

1,674

1,096

3,749

Bond interest.

303

184

788

Preferred dividends.

257

252

761

Common dividends.

Balance to surplus and “volun¬

140

356

609f

tary reserves”.

279

765

1,095

♦After depreciation, but eliminating parent company sinking-fund charges,
t Including $204,000,000 paid in stock.

1 This analysis was made in 1933.

Balance-sheet Changes
(All figures in millions ) 9

BALANCE-SHEET ANALYSIS

629

Is g

J -S

iH ^

+ +

csi

9»

ini

7 i + + +

&|-3

J ^ J

t>- CO
<N <N

+ 1

lO . lO ^ CO

a : 3J *

i : + + +

« a

d s

rH fH

b* CO

»H

CO o cT o

rH CO W5 N

»H CO 05 CO

»H

<N~

Changes
in second
decade

CO CO

+ +

—$109

+ 765

«»

Dec. 31,
1922

$1,466

606

$2,072

$ 571
360

508

633

$2,072

Changes
in first
decade

tF oo

+ +

o ■ r-

M H • ■

M • •

+ i : : +

Dec. 31,
1912

$1,160

256

$1,416

$ 680

360

508

132(d)

$1,416

Dec. 31,
1902

$820

167

$987

• ts

• ^

O O ■ 00 >■*<

00 1—1 • o

CO lO • lO 'St-

$987

Item

Assets:

Fixed (less deprec.) and misc.*.

Net current assets.

Total.

Liabilities :

Bonds.

Preferred stock.

Preferred dividends accrued.

Common stock.

Surplus and “ voluntary ” reserves*.

Total.

* Eliminating initial mark-up of $508,000,000, later written off.
f Including premiums of $81,000,000 and stock dividend of $204,000,000.

630

SECURITY ANALYSIS

C. Relation of Earnings to Average Capital
(All dollar figures in millions)

Item

First

decade

Third

decade

Total for
30 years

Capital at beginning.

$ 987

$1,416

$2,072

$ 987

Capital at end.

1,416

2,072

2,112

Average capital about.

% earned on average capital, per

1,200

1,750

2,100

1,700

year.

% paid per year in interest and divi-

8.1%

9.6%

5.2%

7.4%

dends on average capital.

Average common stock equity (com¬

5.8%

5.2%

4.0%*

5.2%*

mon stock, surplus, and reserves).

$ 237

$ 620

$1,389

$ 816

% earned on common stock equity. .

17.7%

18.3%

4.8%

9.0%

% paid on common stock equity....

5.9%

5.7%

2.9%*

3.7%*

Depreciation per year.

$24

$34

$46

$35

Average fixed property account.

Ratio of depreciation to fixed pro¬

1,000

1,320

1,600

•

1,300

perty.

2.4%

2.6%

2.9%

2.7%

* Excluding stock dividend.

The Significance of the Foregoing Figures .—The three decades
had, superficially at least, a somewhat equal distribution of
good years and bad. In the first decade 1904 and 1908 were
depression years, while 1911 and 1912 were subnormal. The
second period had three bad years, viz., 1914, 1921 and 1922—the
last due to high costs rather than to small volume. The third
decade was made up of eight years of prosperity followed by two
of unprecedented depression.

The figures show that the war period, which occurred in the
middle decade, was a windfall for United States Steel and added
more than 300 millions to profits, as compared with the rate
established in the first ten years. On the other hand, the
last ten years were marked by a drastic falling off in the rate of
earnings on the invested capital. The difference between the
5.2% actually earned and the 8% that might be regarded as a
satisfactory annual average amounted to close to 600 million
dollars for the ten-year period.

Viewing the picture from another angle, we note that in the
thirty years the actual investment in United States Steel Corpora¬
tion was more than doubled and its productive capacity was

BALANCE-SHEET ANALYSIS

631

increased threefold. Yet the average annual production was
only 27 % higher, and the average annual earnings before interest
charges were only 12% higher, in 1923-1932 than in 1903-1912.
This analysis would serve to raise the question: (1) if, since the
end of the war, steel production has been transformed from
a reasonably prosperous into a relatively unprofitable industry
and (2) if this transformation is due in good part to excessive
reinvestment of earnings in additional plant, thus creating a
condition of overcapacity with resultant reduction in the margin
of profit.

Postscript .—The soundness of the foregoing analysis, made
in 1933, may be judged by developments since then. It should
be pointed out that both the plant account figures and the
annual earnings should be adjusted downward in the light of the
later disclosures, viz.: (1) segregation from plant account in
1937 of $269,000,000 (and write-off of this amount in 1938),
representing intangible assets at organization in addition to the
$508,000,000 written off to 1929; (2) a charge to surplus of
$270,000,000 in 1935 for additional amortization of fixed assets,
presumably applicable to the entire preceding period. These
later revisions, however, do not affect in any essential degree
the conclusions drawn above.

The showing of United States Steel in the years since 1932
would appear to bear out the pessimistic implications of the
1933 study. During the six years 1934-1939, which in most
instances supply a fair test period for judging normal earning
power, “Steel” common earned an average of but 14(f per share.
New developments in products, processes or other factors—
including war profits—may change the picture for the better,
but this has become a matter for speculative anticipation of
future improvement rather than a reasonable expectation based
on past performance.

632

SECURITY ANALYSIS

II. Similar Analysis op
Corn Products Repining Company
February 28, 1906; to Dec. 31, 1935

A. Average Annual Income Account
(000 omitted from dollar figures)

1906-1915

1916-1925

1926-1935

Earned before depreciation.

$3,798

$12,770

$14,220

Depreciation.

811

2,538

2,557

Balance for interest and dividends.

2,987

10,232

11,663

Bond interest.

516

264

Preferred dividends (paid or accrued).

2,042

1,879

1,738

Balance for common.

429

8,089

9,837

Common dividends. ....

2,751

5,338

8,421

1,416

Balance to surplus.

429

Balance to surplus for period.. ....

4,290

53,384

14,159

Adjustment of common stock, surplus and
reserves.

cr. 1,282

cr. 6,026

dr. 5,986

Increase in common stock, surplus and
reserves.

5,572

59,410

7,173

B. Balance Sheets

Feb. 28,
1906

Dec. 31,
1915

Dec. 31,
1925

Dec. 31,
1935

Plant (less depreciation) and miscel¬
laneous assets.

Investment in affiliates.

Net current assets.

Total.

$49,000

2,000

1,000

$51,840

4,706

11,091

$ 47,865
16,203
42,528

$ 34,532
33,141
43,192

$52,000

$67,637

$106,596

$110,865

Bonds.

9,571

28,293

14,136

12,763

29,873

19,708

5,293

2,474

25,004

79,118

24,574

86,291

Preferred stock.

Common stock, surplus and miscel¬
laneous reserves.

Preferred dividend accrued.

Total.

$52,000

$67,637

$106,596

$110,865

BALANCE-SHEET ANALYSIS

633

C. Percentage Earned 1 and Paid on Total Capitalization and on
Common-stock Equity

Item

1906-1915

1916-1925

1926-1935

29% years

Average capitalization.

$59,818

$87,116

$108,730

$81,432

Earned thereon.

5.0%

11.8%

10.7%

10.2%

Paid thereon.

4.2%

5.6%

9.4%

7.3%

Average common equity.

$16,922

$49,413

$ 82,704

$50,213

Earned thereon.

2.5%

16.4%

11.9%

12 2%

Paid thereon.

nil

5.6%

10.2%

7.8%

1 Adjustments to Surplus and Reserves arc excluded from earnings.

Notes on Foregoing Computation

1. The plant account and common-fitock equity are corrected throughout
to reflect a write-down of $36,000,000 made in 1922 and 1923.

2. Bonds outstanding arc increased in 1906 and 1912 to reflect liability
for issues of subsidiaries. Plant, etc., is increased in the same amounts.

3. Estimates considered to be sufficiently accurate are used in the initial
balance sheet.

4. Deductions for bond interest are partly estimated for the first two
periods.

5. The adjustments of Common Stock, Surplus and Reserves represent
chiefly changes in Miscellaneous Reserves and shrinkage of marketable
securities.

Comment on the Corn Products Refining Company Exhibit .—The
early period was one of subnormal earnings, which would have
been still poorer if more nearly adequate depreciation charges
had been made. As in the case of United States Steel, the war
period brought enormous earnings to Corn Products. The
decade 1916-1925 was marked as a whole by a great increase in
working capital and a substantial reduction in funded debt and
preferred stock. Depreciation charges exceeded expenditures
on new plant.

In the 1926-1935 period we note a striking divergence from
the exhibit of United States Steel for 1923-1932. Despite
inclusion of the depression years Corn Products was almost able
to increase its earning power proportionately with its enlarged
capital investment. Its annual profits (both before and after
depreciation) were about four times as large in this decade as in
the period ending in 1915. (If we use the same years for com¬
parison, we shall find that United States Steel actually earned
less in 1926-1935 than in 1906-1915.) The balance-sheet

634

SECURITY ANALYSIS

changes were marked by a further substantial shrinkage in the
property account (due to the liberal depreciation charged) but by
a larger increase in the investment in affiliated companies—
indicating a broad expansion of the company’s activities.

It is clear that the record of Corn Products Refining Company
does not suggest the same questions or doubts as arise from an
examination of the United States Steel Corporation’s exhibit.

PART vn

ADDITIONAL ASPECTS OF SECURITY ANALYSIS.
DISCREPANCIES BETWEEN PRICE AND VALUE

CHAPTER XLVI

STOCK-OPTION WARRANTS

During the last two decades the use of stock-option warrants
has passed through an extraordinary development. They were
devised originally as a form of participating privilege for bonds
and preferred stocks to which they were attached. In this
form they were commonly regarded only as a feature of the
senior security, similar to a conversion right, and the warrants
themselves had little significance in relation to the company’s
capitalization structure. Later the idea was hit upon of creating
stock-option warrants separately from other securities and deliv¬
ering them as compensation to underwriters, promoters and
executives. From this point the inevitable next development was
the issuance, through sale or exchange, of separate option war¬
rants to the general public in the same manner as common stocks.
They thus attained full stature as an independent form of “secur¬
ity,” as an important part of the financial set-up of many corpora¬
tions and as a popular and prominent medium of speculative
activity.

In a previous chapter we considered the technical aspects of
option warrants as an adjunct of senior securities. In this
chapter we shall discuss the more important role of option
warrants as a separate financial instrument. Our treatment
falls into three sections: (1) description, (2) technical character¬
istics of warrants as a vehicle of speculation, (3) their significance
as a part of the financial structure.

DESCRIPTIVE SUMMARY

A (detachable) option warrant is a transferable right to buy
stock, originally running for a considerable period of time.

635

636

SECURITY ANALYSIS

(Warrants attached to a debenture bond issue are sometimes
called “Debenture Rights.” A third name for the same thing is
“Stock-purchase Warrant.”) Its terms include: (1) the kind of
stock, (2) the amount, (3) the price, (4) the method of payment,
(5) the duration of the privilege and (6) antidilution provisions.
(The last were described in Chap. XXV.)

Kind of Stock Covered by the Privilege. —Nearly all option
warrants call for common stock of the issuing company. In
rare instances they apply to preferred stock ( e.g ., American
Locker Company, Inc.), or to stock of some other concern (e.g.,
warrants attached to Central States Electric Corporation Pre¬
ferred called for North American Company stock and warrants
attached to Solvay American Investment Corporation preferred
stock called for Allied Chemical and Dye Corporation stock).
Warrants have no right to receive interest, dividends or payments
on account of principal, nor have they the right to cast any vote.

Resemblance to Subscription “Rights.” —Option warrants
bear some resemblance to the “subscription rights” that are
issued by corporations to their stockholders in connection with
the sale of additional stock. There are two significant differences,
however, between warrants and rights. Warrants run for a long
period, and the stock-purchase price is almost always set higher
than the quotation at the time of their issuance. Moreover, the
price is frequently varied in accordance with the terms of the
warrant. Subscription rights run for a short time and call for a
fixed price, usually under the market at the time of their authori¬
zation. Subscription rights are devised, therefore, with the
intent of assuring their exercise and the prompt receipt of funds
by the company. Option warrants generally have no relation
to the financial needs of the company, and they arc not expected
to be exercised in short order. Stated in a different way (and
referring to the usual situation at the time of issuance) a sub¬
scription right will be exercised unless the market declines sub¬
stantially before they expire; option warrants will not be exercised
unless the market price advances substantially in the near or
distant future. 1 Subscription rights generally run for about sixty

1 The Remington-Rand rights, issued in 1936, were a somewhat over-
ingenious combination of the subscription-right and the warrant forms.
If the holder exercised part of his subscription right promptly (at an indi¬
cated market loss, as it happened), he would then have a further right to buy

OTHER ASPECTS OF SECURITY ANALYSIS

637

days; the original duration of option warrants is rarely, if ever,
less than a year, and many of them are perpetual.

Method of Payment. —Most option warrants require payment
of the subscription price in cash.- Those originally attached to
bonds or preferred shares may permit payment either in cash or
by tender of the senior security which is accepted at its face value.
This alternative may be of considerable practical importance.

j Example: Electric Power and Light Warrants are a perpetual
call on common stock at $25 per share. Payment may be made
either in cash or by tendering second preferred stock at $100 per
share. In November 1939 the common stock sold at 8, and the
second preferred at 17. Because of the very low price of the
senior issue, the warrants had an “exercizable value,” even
though the common was selling 17 points below the option price.
The calculation is as follows:

One warrant plus J4 share of second preferred = 1 share of

common

Value of option warrant = 8—34 (17) = 3%

Basis of Trading in Warrants.—Option warrants are bought
and sold in the market in the same way as common stocks. Up
to the end of 1939 only two issues of warrants had been separately
listed on the New York Stock Exchange, 1 but many were actively
dealt in on the New York Curb Exchange and other exchanges.
The basis of trading in these instruments is somewhat eccentric,
and at times conducive to serious error. Under the standard
rule, “one warrant” means the right to buy one share of stock,
and not the right originally attached to one share of stock.

Examples: Walgreen (Drug) Company preferred stock was
sold with warrants entitling the holder to buj r two shares of
common for each preferred share. Under the regular rule of
trading, “one Walgreen Warrant” meant the right to buy one
share of common, i.e., each share of preferred was said to carry
“two warrants.”

more stock up to a year later, and so on. In our view elaborate devices of
this kind either create unnecessary speculative situations or give the adroit
and the well-informed an undue advantage over the ordinary stockholder.

1 Commercial Investment Trust warrants were the only issue in which
active trading took place. Warrants of Havana Electric Railway were
listed on the New York Stock Exchange between 1926 and 1934 but the
trading in them was negligible.

638

SECURITY ANALYSIS

Similarly, Consolidated Cigar Corporation 6^% Preferred
Stock was issued with a warrant attached to each share calling
for the purchase of one-half share of common. These warrants
were also traded in on the basis that one warrant was the right
to buy one share of common; i.e., each share of 63^% preferred
was said to carry “half a warrant.”

But the exceptions to this standard rule are numerous.

Examples: Commercial Investment Trust Corporation
Preferred carried warrants to buy one-half share of common for
each share of preferred (the same ratio as in the case of Consoli¬
dated Cigar Preferred). But the unit of trading on the New
York Stock Exchange was the warrant originally attached to one
share of preferred, i.e., it called for half a share of common.
Similar departures were made in the rules of trading for Niagara
Hudson Power Corporation B Warrants; Loew’s, Inc., Preferred
Warrants; Safeway Stores, Inc., “Old Series” Warrants, etc.

When a change is made in the number of shares called for by
the warrant, the customary procedure is to continue to trade in
“one old warrant” as “one warrant.”

Example: “One Loew’s Bond Warrant” originally called for
one share of common at $55. It represented the warrant
attached to $200 of Loew’s 6% Debentures, due 1941. When a
25% stock dividend was paid in 1928, the antidilution provision
required that an additional quarter share be given free with each
share subscribed for under the warrant. “One Loew’s Bond
Warrant” remained physically unchanged and thereafter repre¬
sented the right to purchase 1)4 shares for $55. Similarly in
the case of Commercial Investment Trust Warrants when the
common stock was split 23^ for 1. One warrant thereafter repre¬
sented the right to buy 1J4 new shares instead of % an old
share.

But the opposite practice is sometimes followed.

Example: Niagara Hudson Power A Warrants. These called
for one share of common at $35. The company recapitalized
in 1932 and issued 1 new share for 3 old. Hence what was
formerly “one warrant” now called for 3^ of a new share for
$35, i.e., at $105 per share. The New York Curb Exchange
thereupon redefined “one A warrant” as representing the right
to buy one new share. Hence three old warrants became one
new warrant.

OTHER ASPECTS OF SECURITY ANALYSIS

639

These technical details are given here because they are not
available in standard descriptive textbooks. Those buying or
selling a particular option warrant are cautioned to make careful
inquiry into the basis of trading therein. 1

Examples of Warrants Issued for Various Purposes. A .
Attached to Senior Securities .—Perhaps the earliest instance is
the issue of American Power and Light notes in 1911. By far the
most prominent is the sale by American and Foreign Power
Company of $270,000,000 of Second Preferred stock carrying
warrants for no less than 7,100,000 shares of common.

B. As Compensation to Underwriters .—The first important
case seems to have been the $25,000,000 Barnsdall Corporation
6% bond issue of 1926. Here the bankers received, as part of
their compensation, warrants for 500,000 shares of common. At
the subsequent high price these warrants would have been worth
$13,000,000. National Fund, Inc., an open-end investment
trust, issued warrants to the sponsors in 1936 in lieu of the cus¬
tomary loading charge. Many flotations of smaller companies
now include large amounts of warrants in addition to cash com¬
pensation for bankers. Examples: Aeronautical Corporation of
America (1939); Triumph Explosives, Inc. (1939); Howard
Aircraft Corporation (1939).

C. As Compensation to Promoters and Management. —A striking
case was the formation of Petroleum Corporation of America
in January 1929. The public was offered 3,250,000 shares of
stock at $34 per share. Five-year warrants to buy 1,625,000
shares at 34 w’crc issued to the promoters and management.

D . Issued in a Merger or Reorganization Plan f in Exchange for
Other Securities. —Commonwealth and Southern Corporation
issued about 17,500,000 warrants, together with 34,000,000 shares
of common and 1,500,000 shares of preferred, mainly in exchange
for securities of six constituent companies. It is interesting to
note that it issued common stock and warrants in exchange for
Penn-Ohio Edison Company and Southeastern Power and Light
Company option warrants.

1 Subscription rights are invariably dealt in in New York on the basis of
“one right” meaning the right received by the owner of one share of stock.
This is the opposite idea from that ordinarily followed in option warrants.
See Appendix Note 63, p. 802, for a rapid method of calculating the value of
subscription rights.

640

SECURITY ANALYSIS

In the 1937 reorganization of Baldwin Locomotive Works the
old preferred and common were both exchanged for new common
and warrants. In the Colorado Fuel and Iron reorganization
of 1936 only warrants were given for the old preferred and com¬
mon. The reorganization plan for Erie Railroad, presented in
1938 in behalf of insurance companies holding bonds, was unique
in that it gave old stockholders warrants to buy new common
from the old creditors instead of from the company.

E. Attached to an Original Issue of Common Stock .—Public
Utility Holding Corporation of America sold 2,500,000 shares of
common stock, carrying warrants to buy an equal number of
shares of additional common. In addition, the organizing
interests purchased 500,000 shares of Class A stock (with voting
control) together with warrants to buy 1,000,000 shares of either
Class A or common stock.

F. Sold Separately for Cash .—In 1929 Fourth National Inves¬
tors Corporation sold to its parent company 750,000 option
warrants for $3,000,000. In 1936 Phillips Packing Company
sold warrants to bankers for cash.

WARRANTS AS A VEHICLE OF SPECULATION

In a broad sense, option warrants possess the same general
characteristics as low-priced common stocks, the theory of which
was discussed in Chap. XLI. Warrants arc in name and in form,
as low-priced stocks frequently are in essence, a long-term call
upon the future of a business. 1 It is true also that the relation¬
ship between a warrant and its common stock is roughly similar
to that between a common stock and a speculative senior security
of the same company.

The Qualitative Element. —As with all other speculative
commitments, the attractiveness of a given warrant depends
upon two entirely dissimilar factors: the qualitative element,
being the nature of the enterprise, in relation particularly to its
supposed chance of great improvement; and the quantitative
element, being the terms on which the warrant is offered, includ¬
ing its price and the price of the common stock it calls for.

1 In a few cases warrants are issued to run for a comparatively short time.
In such a case they are more a call on the future of the stock market than of
the business. Example: The warrants of Phillips Packing Company referred
to above ran for only two years.

OTHER ASPECTS OF SECURITY ANALYSIS 641

Security analysis cannot be counted upon to reveal those busi¬
nesses which are most likely to forge ahead in the years to come.
There is not much we can say, therefore, about the qualitative
element in selecting warrants for speculation. Since ordinarily
a warrant can attain tangible value only through an increase
in earnings, emphasis must be laid upon the prospects of change
rather than upon stability. Public-utility warrants, for example,
became extremely popular in 1928-1929 not because of the
superior stability of utility enterprises but because the market
was convinced that their earnings would continue to expand
indefinitely.

As far as the arithmetical chance of a large price advance is
concerned, we have already shown that this is most likely to be
found in the common stock of speculatively capitalized enter¬
prises ( e.g ., A. E. Staley Company and American Water Works
and Electric, discussed in Chap. XL.) Hence warrants to buy
common stocks of this kind may also be said to have a special
speculative advantage. But this is at bottom a quantitative
rather than a qualitative matter. In our view, it is rarely possi¬
ble to say with assurance that the long-term prospects of a
particular line of business arc so much better than the average as
to make warrants connected with that field more attractive than
any others. But if the individual speculator has definite opinions
and preferences on this score, it is perfectly logical for him to
follow them.

Quantitative Considerations: Importance of Low Price.—It is

an easier matter to point out the elements that govern the
relative attractiveness of warrants from a quantitative stand¬
point. The desirable qualities are: first, a low price; second, a
long duration; and thirdly, an option (or purchase) price close
to the market. From the standpoint of speculative theory, the
most important of the three no doubt is a low price for the war¬
rant. This may be brought out by a comparison of the situation
existing in the Sinclair Oil and Refining Corporation Warrants in
1917 and Niagara Hudson Power Corporation B Warrants in
1929.

Examples: The warrant attached to each $1,000 Sinclair Oil
and Refining Corporation note, issued in 1917, entitled the
holder to buy 25 shares of stock at $45 per share until August 1,
1918; at 47}4 until August 1, 1919; and at 50 until February 1,

642

SECURITY ANALYSIS

1920. In December 1917 the stock had declined to 25%, and a
warrant for 25 shares could be bought at $20, i.c., at a cost of
only 80 cents per share. Here the market price of the stock was
far below the option price, but the option could be acquired at a
very low cost per share. The sequel was quite characteristic
of speculative markets. In less than 18 months Sinclair Oil
stock rose to 69% giving a warrant for 25 shares a realizable
value of over $550. An increase of 175% in the price of the
stock produced an increase of 2,680% in the price of the warrant.

The Niagara Hudson Power Corporation B Warrants entitled
the holder to buy 3% shares of common for $50, i.e., at $14,285
per share. When the warrants were admitted to trading on the
New York Curb in 1929, they sold at 60—equivalent to 17 for a
one-share warrant—while the stock was selling at 22%. In this
case the speculator was paying nearly as much per share for the
warrants as for the stock. When the latter advanced to its high
of 31 later in the year, the warrants rose by a much smaller
percentage, to 21. Still later in the same year, the price of the
stock broke to 11%, and then the warrants collapsed to a low of 2.
These comparative figures show that at the equivalent of 17
the Niagara Hudson B Warrants were selling at an extraordi¬
narily unattractive price.

Low Relative Price Important .—It is technically desirable that
the price of a warrant be low not only in itself but also in relation
to the price of the common stock. This point may be shown by a
comparison of Commercial Investment Trust Corporation
Warrants in 1928 with American and Foreign Power Company
Warrants in 1933.

Examples: Commercial Investment Trust Corporation War¬
rants sold at $6 each in August 1928. They entitled the holder
to buy % share of common at $90 per share until the end of
1929 and at 100 thereafter until January 1, 1931. The common
was then selling at about 70. The warrant for 1 share thus
represented a commitment of $12, or about % the current value
of the stock. Despite the relatively high purchase price specified
in the warrant, the latter might be considered as having a specula¬
tive advantage over the stock because of the much smaller money
cost involved. (As it happened, the price of the warrants
advanced elevenfold in 1928-1929 as against a threefold rise in
the common.) As shown on page 666, in November 1933,

OTHER ASPECTS OF SECURITY ANALYSIS

643

warrants for one share of American and Foreign Power could be
bought at 7, representing exact parity with the common. But
the fact that the common was itself selling at only 10 removed
any special speculative advantage from the warrants at 7. As
we shall see later, it throws the stock and the warrants together
into the category of “pseudo” low-priced speculations, of the
kind discussed at the beginning of Chap. XLI.

The foregoing discussion leads to the conclusion that a given
option warrant has speculative attractiveness, in a technical
sense, only if it constitutes a low-cost, long-term right to purchase
a stock at a price not too remote from the current market. 1

Examples: The Sinclair Oil and Commercial Investment Trust
Warrants, referred to above, are examples that met these require¬
ments. An unusual example is furnished by the Barnsdall Oil
warrants in 1927. These were a call on the stock at 25. When
the shares were selling at 31, the warrants sold at 6, exactly at
parity. In this case, any rise in the value of the stock would have
meant—and later did mean—a much larger proportionate rise
in the price of the warrants.

Technical Advantages Often Absent .—During 1928-1929, when
trading in warrants was most active, there was a tendency
for these instruments to sell at high levels, both relatively and
absolutely, so that they could not be said to possess any technical
advantage over the typical common stock. During the ensuing
depression many warrant issues were obtainable at very low
prices, but here again the related common shares were also quoted
so low as to call into question the comparative attractiveness of
the warrant. The situation at the close of 1939 may be illus¬
trated by the representative list of warrants shown in the table
on page 644.

It is to be noted that the warrants carrying the right to make
payment by turning in a bond or preferred issue at par were
generally selling at an interesting price in relation to the common
stock. (The Electric Power and Light warrants were actually
quoted below parity.) The other low-priced warrants seemed too
far away from realizable value to merit attention. The Baldwin
Locomotive and New York City Omnibus price relationships

1 See Dewing, Arthur S., A Study of Corporation Securities , pp. 404-405,
New York, 1934, for a study of the relative attractiveness of warrants and
their related common stocks as speculative vehicles.

644

SECURITY ANALYSIS

Name of corporation
issuing warrant

Duration

Purchase
price
of stock
named in
warrant

Market
price of
stock

Market
price of
warrant

American & Foreign Power.

Perpetual

25 or
i%*

Atlas Corp.

Perpetual

25 or
23% *

Baldwin Locomotive Co.

To Sept. 1, 1945

17%

Electric Power & Light Corp.

Perpetual

25 or 4*

Manati Sugar Co.

To Nov. 5, 1947

12^ or

Merritt-Chapman & Scott

Corp.

Perpetual

N. Y. City Omnibus Corp...

To Mar. 1, 1947

17%

32%

17%

Scullin Steel Co.

To May 1, 1942

10 or
6%*

3%t

Tri-Continental Corp.

Perpetual

22%

United Corp.

Perpetual

* Cost in terms of current price of senior securities tenderable in lieu of cash,
t Market price of 4 warrants, equivalent to 1 share of common.

are typical of their respective stages in the scale of market
values. 1

WARRANTS AS PART OF THE CAPITALIZATION STRUCTURE

Option warrants are essentially a device to give separate
embodiment to the element of future prospects. But the right
to benefit from future improvement or enhancement belongs
inherently to the common stockholder. It is one of the impor¬
tant considerations that he receives in return for putting up his
money and taking the “first risk” of loss. The basic fact about
an option warrant, therefore, is that it represents something that
has been taken away from the common stock. The equation is
a simple one:

Value of common stock + value of warrants = value of
common stock alone (i.e., if there were no warrants).

l For an effort towards a mathematical formulation of the value of
warrants see John B. Williams, The Theory of Investment Value , pp. 172-178,
Harvard University Press, 1938.

OTHER ASPECTS OF SECURITY ANALYSIS

645

Warrants Represent a Subtraction from the Related Stock.—

Example: This point may be illustrated concretely by reference
to the effect of the issuance of the Barnsdall warrants upon the
value of the stock. The earnings reported for 1926 were $6,077,-
000, or $5.34 per share on 1,140,000 shares outstanding. How¬
ever, there were also in existence warrants to buy 1,000,000
shares at $25, the proceeds to be applied to retire $25,000,000 of
6% bonds. The analyst should have assumed exercise of the
warrants, thus reducing the 1926 earnings from $5.34 to $3.54
per share. In 1929, the warrants having actually been exercised,
the earnings were $3.25 per share, as against $4.76 if there had
been no warrants created. The average price of 35 for the year
was equivalent to a value of 10 for the warrants. This meant,
substantially, that about $8 per share had been taken away from
the value of the common stock (which otherwise would have
been worth 43) by the creation of the warrants.

This illustration shows clearly that the effect of the creation
of warrants is to diminish the benefits realized by the common
from a large increase in the earnings or in the value of the
business. Warrants to buy stock, even at a price above the
market, therefore detract from the present value of the common
stock, because part of this present value is based upon the right
to benefit from future improvement.

A Dangerous Device for Diluting Stock Values.—The option
warrant is a fundamentally dangerous and objectionable device
because it effects an indirect and usually unrecognized dilution
of common-stock values. The stockholders view the issuance
of warrants with indifference, failing to realize that part of their
equity in the future is being taken from them. The stock
market, with its usual heedlessness, applies the same basis of
valuation to common shares whether warrants are outstanding
or not. Hence warrants may be availed of to pay unreasonable
bonuses to promoters or other insiders without fear of compre¬
hension and criticism by the rank and file of stockholders.
Furthermore, the warrant device facilitates the establishment of
an artificially high aggregate market valuation for a company’s
securities, because (with a little manipulation) large values can
be established for a huge issue of warrants without reducing the
quotation of the common shares.

646

SECURITY ANALYSIS

Stock-option warrants have proved a convenient and appealing
instrument in corporate reorganizations, because they have
enabled the reorganizers to give the old stockholders a sop of some
kind while ostensibly turning the company over entirely to the
creditors. The S.E.C., however, has taken a stand against this
practice, contending that if the old stockholders really have
no equity they are not even entitled to warrants. 1

A Redudio ad Absurdum .—The public’s failure to comprehend
that all the value of option warrants is derived at the expense of
the common stock has led to a practice that would be ridiculous
if it were not so mischievous. We refer to the original sale of
common stock carrying warrants to buy additional common
stock. This arrangement gives nothing to the stockholders
that they would not have without the warrant, and it violates
an obvious rule of sound corporate financing. A properly
managed business sells additional stock only when new capital
is needed , and in that event the stockholders are usually entitled
to subscribe pro rata to the offering. 2 To give subscription
rights to stockholders when the money is not needed is non¬
sensical from all viewpoints except that of deceiving people into
believing that something attractive is being offered them. It
resembles the practice', sometimes indulged in, of declaring
dividends in “scrip” which is redeemable at the pleasure of the
directors. This “scrip” is an unnecessary expression in separate
form of a right that the common stock possesses inherently,
viz., to receive future dividends when the directors see fit to pay
them. 8 Similarly these option warrants attached to original

1 See their advisory opinion in the National Radiator case (in March
1939) which led to the dropping of a warrant provision for old stockholders.
In our opinion the broad objections to the warrant device in principle may
justify the rather Draconian stand of the S.E.C. But a warrant arrange¬
ment under which old stockholders can buy out old creditors at a price
that will pay them off, e.g., the Erie plan, dated January 1939, has much
more to recommend it.

2 It has become fashionable to insert charter provisions that deprive
stockholders of this so-called “preemptive right.” It is claimed that the
surrender of this right is necessary in order to give the directors more flexible
powers in making corporate deals involving issuance of stock. We are very
sceptical of the soundness of this argument.

* Cities Service Company paid dividends in scrip of this kind between
1921 and 1925, redeeming it in the latter year. Since its value depended
almost entirely on the whim of the directors, it was the sort of speculative

OTHER ASPECTS OF SECURITY ANALYSIS

647

issues of common stock are a superfluous expression of the stock¬
holders’ inherent right to participate in future stock offerings. 1

A further study of the unwholesome implications of the warrant
device is integrated with two broader lines of inquiry into
financial practices—the first relating to the price paid by the
public for the financing and management of business; the second
relating to that group of manipulative and dangerous corporate
practices referred to as “ pyramiding.” These aspects of security
analysis will be considered in the ensuing chapters.

medium that gives an enormous advantage to insiders. Gas Securities
Company, a subsidiary of Cities Service, paid dividends in scrip of this
kind during 1933.

1 For a recent example of this species of financing see offering of Berkey
and Gay Furniture Company common stock and warrants in January 1936.

CHAPTER XLVII

COST OF FINANCING AND MANAGEMENT

Let us consider in more detail the organization and financing
of Petroleum Corporation of America, mentioned in the last
chapter. This was a large investment company formed for the
purpose of specializing in securities of enterprises in the oil
industry. The public was offered 3,250,000 shares of capital
stock at $34 per share. The company received therefore a net
amount of $31 per share, or $100,750,000 in cash. It issued to
unnamed recipients—presumably promoters, investment bankers
and the management—warrants, good for five years, to buy
1,625,000 shares of additional stock, also at $34 per share.

This example is representative of the investment trust financing
of the period. Moreover, as we shall see, the technique on this
score that developed in boom years was carried over through
the ensuing depression, and it threatened to be accepted as the
standard practice for stock financing of all kinds of enterprises.
But there is good reason to ask the real meaning of a set-up of
this kind, first, with respect to what the buyer of the stock gets
for his money, and second, with respect to the position occupied
by the investment banking houses floating these issues.

Cost of Management; Three Items. —A new investment trust—
such as Petroleum Corporation in January 1929—starts with two
assets: cash and management. Buyers of the stock at $34 per
share were asked to pay for the management in three ways, vie.:

1. By the difference between what the stock cost them and
the amount received by the corporation.

It is true that this difference of $3 per share was paid not to
the management but to those underwriting and selling the shares.
But from the standpoint of the stock buyer the only justification
for paying more for the stock than the initial cash behind it
would lie in his belief that the management was worth the
difference.

648

OTHER ASPECTS OF SECURITY ANALYSIS

649

2. By the value of the option warrants issued to the organizing
interests.

These warrants in essence entitled the owners to receive one-
third of whatever appreciation might take place in the value of
the enterprise over the next five years. (From the 1929 view¬
point a five-year period gave ample opportunity to participate
in the future success of the business.) This block of warrants
had a real value, and that value in turn was taken out of the
initial value of the common stock.

The price relationships usually obtaining between stock and
warrants suggest that the 1,625,000 warrants would take about
one-sixth of the value away from the common stock. On this
basis, one-sixth of the $100,750,000 cash originally received by
the company would be applicable to the warrants, and five-sixths
to the stock.

3. By the salaries that the officers were to receive, and also
by the extra taxes incurred through the use of the corporate form.

Summarizing the foregoing analysis, we find that buyers of
Petroleum Corporation shares were paying the following price
for the managerial skill to be applied to the investment of their
money:

1. Cost of financing ($3 per share). $ 9,750,000

2. Value of warrants of remaining cash). about 16,790,000

3. Future deductions for managerial salaries, etc . ?

Total . ..$26,540,000 +

The three items together may be said to absorb between
25 and 30% of the amount contributed by the public to the enter¬
prise. By this we mean not merely a deduction of that percent¬
age of future profits but an actual sacrifice of invested principal
in return for management.

What Was Received for the Price Paid ?—Carrying the study a
step farther, let us ask what kind of managerial skill this enter¬
prise was to enjoy? The board of directors consisted of many
men prominent in finance, and their judgment on investments
was considered well worth having. But two serious limitations
on the value of this judgment must here be noted. The first is
that the directors were not obligated to devote themselves
exclusively or even preponderantly to this enterprise. They
were permitted, and seemingly intended, to multiply these

850

SECURITY ANALYSIS

activities indefinitely. Common sense would suggest that the
value of their expert judgment to Petroleum Corporation would
be greatly diminished by the fact that so many other claims were
being made upon it at the same time.

A more obvious limitation appears from the Corporation's
projected activities. It proposed to devote itself to investments
in a single field—petroleum. The scope for judgment and
analysis was thereby greatly circumscribed. As it turned out,
the funds were largely concentrated, first in two related com¬
panies—Prairie Pipe Line Company and Prairie Oil and Gas
Company—and then in a single successor enterprise (Consoli¬
dated Oil Corporation). Thus Petroleum Corporation took on
the complexion of a holding company, in which the exercise of
managerial skill appears to be reduced to a minimum once the
original acquisitions are made. 1

We are forced to conclude that financial schemes of the kind
illustrated by Petroleum Corporation of America are unsatis¬
factory from the standpoint of the stock buyer. This is true not
only because the total cost to him for management is excessive
in relation to the value of the services rendered but also because
the cost is not clearly disclosed, being concealed in good measure
by the use of the warrant artifice. 2 (The foregoing reasoning does
not rest in any way upon the fact that Petroleum Corporation's
investments proved unprofitable. 3 )

1 The same logical objection to the payment of a large “managerial
bonus,” in the form of option warrants to those organizing a holding com¬
pany, may be urged against the set-up of Alleghany Corporation and United
Corporation.

2 In a series of “Notes” on the history of United Corporation financing
by Sanford L. Schamus, in Columbia Law Review of May, June and Novem¬
ber, 1937, the proposal was advanced that prospectuses issued under
S.E.C. legislation should carry a tabulation showing the effect of the exercise
of warrants on earnings and asset values, gee November 1937 issue, pp.
1173-1174.

3 A review of the operations of Petroleum Corporation, published by the
S.E.C. in May 1939, criticizes severely a number of deals in which the
management was interested on the other side. After 1933 a unique turn
was given to the status of Petroleum Corporation through acquisition of a
large interest (39.8%) therein by Consolidated Oil. The two companies
thus became the largest stockholders of each other, an extraordinary and
highly objectionable situation. See Part 3, Chap. II (2d sec.), of the Report
of the S.E.C . on Investment Trusts and Investment Companies.

OTHER ASPECTS OF SECURITY ANALYSIS

651

Position of Investment Banking Firms in This Connection.—

The second line of inquiry suggested by this example is also of
major importance. What is the position occupied by the invest¬
ment banking firms floating an issue such as Petroleum Corpora¬
tion of America, and how does this compare with the practice of
former years? Prior to the late 1920’s, the sale of stock to the
public by reputable houses of issue was governed by the following
three important principles:

1. The enterprise must be well established and offer a record and financial
exhibit adequate to justify the purchase of the shares at the issue price.

2. The investment banker must act primarily as the representative of
the buyers of the stock, and he must deal at arm’s-length with the company’s
management. His duty includes protecting his clients against the payment
of excessive compensation to the officers or any other policies inimical to
the stockholders’ interest.

3. The compensation taken by the investment banker must be reasonable.
It represents a fee paid by the corporation for the service of raising capital.

These rules of conduct afforded a clear line of demarcation
between responsible and disreputable stock financing. It was
an established Wall Street maxim that capital for a new enter¬
prise must be raised from private sources. 1 These private
interests would be in a position to make their own investigation,
work out their own deal and keep in close touch with the enter¬
prise, all of which safeguards (in addition to the chance to make
a large profit) were considered necessary to justify a commitment
in any new venture. Hence the public sale of securities in a
new enterprise was confined almost exclusively to “blue sky”
promoters and small houses of questionable standing. The
great majority of such flotations were either downright swindles
or closely equivalent thereto by reason of the unconscionable
financing charges taken out of the price paid by the public.

Investment-trust financing, by its very nature, was compelled
to contravene these three established criteria of reputable stock

1 An apparent exception might bo made sometimes in a case such as Chile
Copper Company where the demonstrated presence of huge bodies of ore
was regarded as justifying public financing to bring the mine into production.
The sale of stock of the Lincoln Motor Company in 1920 was one of the
few real exceptions to the rule as here stated. In this instance an unusually
high personal reputation was behind the enterprise, but it resulted in
disastrous failure.

652

SECURITY ANALYSIS

flotations. The investment trusts were new enterprises; their
management and their bankers were generally identical; the
compensation for financing and management had to be deter¬
mined solely by the recipients, without accepted standards of
reasonableness to control them. In the absence of such stand¬
ards, and in the absence also of the invaluable arm’s-length
bargaining between corporation and banker, it was scarcely to be
hoped that the interests of the security buyer would be adequately
protected. Allowance must be made besides for the generally
distorted and egotistical views prevalent in the financial world
during 1928 and 1929.

Developments since 1929.—For a time it appeared that the
demoralizing influence of investment-trust financing was likely
to spread to the entire field of common-stock flotations and that
even the leading banking houses were prepared to sell shares of
new or virtually new commercial enterprises, without past records
and on the basis entirely of their expected future earnings.
(There were definite signs of this tendency in the beer- and
liquor-stock flotations of 1933.) Fortunately, a reversal of senti¬
ment has since taken place, and we find that the relatively few
common-stock issues sponsored by the first-line houses are now
similar in character and arrangements to those of former days. 1

However, there has been a fair amount of activity in the com¬
mon-stock flotation field since 1933, carried on by houses of
secondary size or standing. Most of these issues represent
shares of new enterprises, which in turn tend to fall in whatever
industrial group is easiest to exploit at the time. Thus in 1933
we had many gold-, liquor- and beer-stock flotations, and in
1938-1939 there was a deluge of airplane issues. The formation
of new investment companies, on the other hand, appears to be a
perennial industry. In surveying such common-stock flotations,
the starting point must be the realization that the investment
banker behind them is not acting primarily in behalf of his clients
who buy the issue. For on the one side the new corporation is
not an independent entity, which can negotiate at arm’s-length
with various bankers representing clients with money to invest,
and on the other side, the banker is himself in part a promoter, in

1 See, for example, the offerings of New Idea Company common in 1937,
General Shoe Company common in 1938, Julius Garfmckel and Company
in 1939.

OTHER ASPECTS OF SECURITY ANALYSIS

653

part a proprietor of the new business. In an important sense, he
is raising funds from the public for himself '.

New Role of Such Investment Bankers. —More exactly stated,
the investment banker who floats such issues is operating in a
double guise. He makes a deal on his own behalf with the
originators of the enterprise, and then he makes a separate deal
with the public to raise from them the funds he has promised
the business. He demands—and no doubt is entitled to—a
liberal reward for his pains. But the very size of his compensa¬
tion introduces a significant change in his relationship to the
public. For it makes a very real difference whether a stock buyer
can consider the investment banker as essentially his agent and
representative or must view the issuing house as a promoter-
proprietor-manager of a business, endeavoring to raise funds to
carry it on.

When investment banking becomes identified with the latter
approach, the interests of the general public are certain to suffer.
The Securities Act of 1933 aims to safeguard the security buyer
by requiring full disclosure of the pertinent facts and by extending
the previously existing liability for concealment or misrepresenta¬
tion. Although full disclosure is undoubtedly desirable, it may
not be of much practical help except to the skilled and shrewd
investor or to the trained analyst. It is to be feared that the
typical stock buyer will neither read the long prospectus carefully
nor understand the implications of all it contains. Modern
financing methods are not far different from a magician’s bag of
tricks; they can be executed in full view of the public without its
being very much the wiser. The use of stock options as part of
the underwriter-promoter’s compensation is one of the newer and
more deceptive tricks of the trade.

Two examples of new enterprise financing, in 1936 and 1939,
will be discussed in some detail, with the object of illustrating
both the character of these flotations and the technique of
analysis required to appraise them. 1

1 In the 1934 edition we analyzed, at this point, the offering of stock
in Mouquin, Inc. (liquor importers) made in September 1933 at $6.75 per
share. The facts showed that the public was asked to place a valuation of
$1,670,000 on an enterprise with physical assets of $424,000 and no earnings
record. The company passed out of existence in 1937, and the public’s
investment was wiped out.

654

SECURITY ANALYSIS

Example A: American Bantam Car Corporation , July 1936.—
This offering consisted of 100,000 shares of 6% Cumulative Con¬
vertible Preference stock, sold to the public at $10 per share, its
par value. Each share was convertible into 3 shares of common
stock. The “underwriters” received a gross commission of $2
per share, or 20% of the selling price; however, this compensation
was for selling effort only, without any guarantee to take or place
the shares.

The new company had acquired the plant of the American
Austin Car Company, which had started out in 1929 with $3,692,-
000 in cash capital and had ended in bankruptcy. The organizers
of the Bantam enterprise bought in the Austin assets, subject
to various liabilities, for only $5,000. They then turned over
their purchase, plus $500 in cash, to the new company for
300,000 shares of its common stock. In other words, the entire
common issue cost the promoters $5,500 cash plus their time
and effort.

The prospectus stated—what was an obvious fact—that the
preference stock was “offered as a speculation. ,, That specula¬
tion could work out successfully only if the conversion privilege
proved valuable, since the mere 6% return on a preferred stock
was scarcely an adequate reward for the risk involved. (The
character of the risk was shown clearly enough in the enormous
losses of the predecessor company.) But note that before the
conversion privilege could be worth anything, the common stock
would have to sell for more than $3^ per share—and in that case
the $5,500 investment of the organizers would he worth over $1,000,-
000. In other words, before the public could make any profit, the
organizers would have to multiply their stake 180 times.

Sequel. By June 30, 1939, the company had accumulated a
deficit of $750,000; it was compelled to borrow money from the
R.F.C., and the preferred-stock holder no longer had any equity
in current assets. The price of the preference stock declined
to 3, but at the same time the common was quoted at % bid.
This meant (if the quoted price could be trusted) that, although
the public had lost 70% of its investment, the organizers , $5,500
contribution had still a nominal market value of $225,000.

Example B: Aeronautical 'Corporation of America ) December
1939.—This company offered to the public 60,000 shares of new
common stock at $6.25 per share. The “underwriters,” who

OTHER ASPECTS OF SECURITY ANALYSIS

655

made no firm commitment to take any shares, received on the
sale of each share the following three kinds of compensation: (1)
90 cents in cash; (2) 3^o °f a share of stock, ostensibly worth 31
cents, donated by the principal stockholders; (3) a warrant to buy
3^ share of stock at prices varying between $6.25 and $8.00 per
share. If the common stock was fairly worth the $6.25 offering
price, these warrants were undoubtedly worth at least $1 per
share called for. This would mean an aggregate commission for
selling effort of $2.34 per share, or more than one-third the
amount paid over by the public.

The company had been in business since 1928 and had been
manufacturing its light Acronca planes since 1931. Its business
had grown steadily from $124,000 sales in 1934 to about $850,000
sales in 1939. However, the enterprise had been definitely
unprofitable to the end of 1938, showing an aggregate deficit at
that time of over $500,000 (including development expense
written off). In 9J^ months to October 15, 1939, it had earned
$50,000. Prior to this offering of new shares to the public there
were outstanding 66,000 shares of stock, which had a net asset
value of only $1.28 per share. In addition to the warrants for
30,000 shares to be given the underwriters, there were like war¬
rants for 15,000 shares in the hands of the officers.

There seemed strong reason to believe that the company
occupied a favorable position in a growing industry. But
analysis would show that the participation of the public in any
future increase in earnings was seriously diluted in three different
ways: by the cash selling expense subtracted from the price to be
paid for the new stock, by the small tangible assets contributed
by the original owners for their stock interest and by the warrants
which would siphon off part of any increased value. To show the
effect of this dilution, let us assume that the company proves so
successful that its fair value is twice its tangible assets after com¬
pletion of this financing—say, about $1,000,000 as compared
with $484,000 of tangible assets. What could then be the value
of the stock for which the public paid $6.25? If there were no
warrants outstanding, this value would be about $8 per share on
126,000 shares. But allowing for a value of say $2.00 per share
for the warrants, the stock itself would be worth only $7.25 per
share. Hence even a very substantial degree of success on the
part of this enterprise would add a mere 16% to the value of the

656

SECURITY ANALYSIS

public’s purchase. Should things go the other way, a very large
part of the investment would soon be dissipated.

Should the Public Finance New Ventures? —Fairly complete
observation of new-enterprise financing registered with the S.E.C.
since 1933 has given us a pessimistic opinion as to its soundness
and its economic value to the nation. The venturing of capital
into new businesses is essential to American progress, but no
substantial contribution to the upbuilding of the country has ever
been made by new ventures publicly financed. Wall Street has
always realized that the capital for such undertakings should
properly be supplied on a private and personal basis—by the
organizers themselves or people close to them. Hence the sale of
shares in new businesses has never been a truly reputable pursuit,
and the leading banking houses will not engage in it. The less
fastidious channels through which such financing is done exact so
high an over-all selling cost —to the public —that the chance of
success of the new enterprise, small enough at best, is thereby
greatly diminished.

It is our considered view that the nation’s interest would be
served by amending the Securities Act so as to prohibit the public
offering of securities of new and definitely unseasoned ventures.
It would not be easy to define precisely the criteria of “ season¬
ing,”— e.g ., size, number of years’ operation without loss—and
it may be necessary to vest some discretion on this score with the
S.E.C. We think, however, that borderline and difficult cases
will be relatively few in number (although our second example
above belongs, perhaps, in this category). We should be glad
to see the powers and duties of the S.E.C. diminished in many
details of minor significance; but on this point of protecting a
public incapable of protecting itself, our view leans strongly
towards more drastic legislation.

Blue-sky Promotions. —In the “good old days” fraudulent
stock promoters relied so largely upon high pressure salesmanship
that they rarely bothered to give their proposition any semblance
of serious merit. They could sell shares in a mine that was
not even a “hole in the ground” or in an invention the chief
recommendation for which was the enormous profit made by
Henry Ford’s early partners. The victim was in fact buying
“blue sky” and nothing else. Any one with the slightest busi¬
ness sense could have detected the complete worthlessness of

OTHER ASPECTS OF SECURITY ANALYSIS

657

these ventures almost at a glance; in fact, the glossy paper used
for the prospectus was in itself sufficient to identify the proposi¬
tion as fraudulent.

The tightening of federal and‘state regulations against these
swindles has led to a different type of security promotion.
Instead of offering something entirely worthless, the promoter
selects a real enterprise that he can sell at much more than its
fair value. By this means the law can be obeyed and the public
exploited just the same. Oil and mining ventures lend them¬
selves best to such stock flotations, because it is easy to instill
in the uninitiated an exaggerated notion of their true worth. The
S.E.C. has been concerning itself more and more seriously with
endeavors to defeat this type of semifraud. In theory a pro¬
moter may offer something worth $1 per share at $5, provided he
discloses all the facts and adds no false representations. The
Commission is not authorized to pass upon the soundness of new
securities or the fairness of their price (except in the case of
public-utility issues which come under the terms of the Public
Utility Holding Company Act of 1935). Actually, it appears to
be doing its best, by various pressures, to discourage and even
prevent the more grossly inequitable offerings. But it is essen¬
tial that the public recognize that the Commission’s powers in
this respect are severely limited and that only a sceptical analysis
by the intending buyer can assure him against exploitation.

Promotional activities are attracted especially to any new
industry that is in the public eye. Profits made by those first in
the field, or even currently by the enterprise floated, can be given
a fictitious guise of permanence and of future enhancement.
Hence gross overvaluations can be made plausible enough to
sell. In the liquor flotations of 1933 the degree of overvaluation
depended entirely upon the conscience of the sponsors. Accord¬
ingly, the list of stock offerings showed all gradations from the
thoroughly legitimate down to the almost completely fraudulent. 1
A somewhat similar picture is presented by the aircraft flotations
of 1938-1939. The public would do well to remember that
whenever it becomes easy to raise capital for a particular indus¬
try, both the chances of unfair deals are magnified and the dangei
of overdevelopment of the industry itself becomes very real.

l See Appendix Note 55, p. 782, relative to investors’ experience with
brewery-stock flotations of 1933.

658

SECURITY ANALYSIS

Repercussions of Unsound Investment Banking. —The relax¬
ation of investment banked standards in the late 1920 , s, and
their use of ingenious means to enlarge their compensation, had
unwholesome repercussions in the field of corporate management.
Operating officials felt themselves entitled not only to handsome
salaries but also to a substantial participation in the profits
of the enterprise. In this respect the investment-trust arrange¬
ments, devised by the banking houses for their own benefit, set
a stimulating example to the world of “big business.”

Whether or not it is proper for executives of a large and pros¬
perous concern to receive annual compensation running into
hundreds of thousands or even millions of dollars is perhaps
an open question. Its answer will depend upon the extent to
which the corporation's success is due to their unique or sur¬
passing ability, and this must be very difficult to determine
with assurance. But it may not be denied that devious and
questionable means were frequently employed to secure these
large bonuses to the management without full disclosure of their
extent to the stockholders. Stock-option warrants (or long¬
term subscription rights) to buy shares at low prices, proved
an excellent instrument for this purpose—as we have already
pointed out in our discussion of stockholder-management rela¬
tionships. In this field complete and continued publicity is
not only theoretically desirable but of practical utility as well.
The legislation of 1933-1934 marks an undeniable forward step
in this regard, since the major facts of managerial compensation
must now be disclosed in registration statements and in annual
supplements thereto (Form 10-K). With publicity given to this
compensation, we believe that the self-interest of stockholders
may be relied on fairly well to prevent it from passing all reason¬
able limits.

CHAPTER XLVIII

SOME ASPECTS OF CORPORATE PYRAMIDING

Pyramiding in corporate finance is the creation of a speculative
capital structure by means of a holding company or a series
of holding companies. Usually the predominating purpose of
such an arrangement is to enable the organizers to control a
large business with the investment of little or no capital and
also to secure to themselves the major part of its surplus profits
and increased going-concern value. The device is most often
utilized by dominant interests to “cash in” speculative profits
on their holdings and at the same time to retain control. With
the funds so provided, these successful captains of finance
generally endeavor to extend their control over additional
operating enterprises. The technique of pyramiding is well
illustrated by the successive maneuvers of O. P. and M. J. Van
Sweringen, which started with purchase of control of the then
relatively unimportant New York, Chicago, and St. Louis Rail¬
road and rapidly developed into a far-flung railroad “empire .” 1

Example: The Van Sweringen Pyramid .—The original trans¬
action of the Van Sweringens in the railroad field took place in

1 The complete story of how this pyramiding was effected is told in the
Hearings before the Committee on Banking and Currency, United States
Senate , 73d Congress, 1st Session, on Senate Resolution 84 of the 72d Con¬
gress and Senate Resolution 56 of the 73d Congress, Part 2, pp. 563-777,
June 5 to 8, 1933—on “ Stock Exchange Practices.” The story is also set
forth in greater detail and with graphic portrayal in Regulation of Stock
Ownership in Railroads , Part 2, pp. 820-1173 (House Report No. 2789, 71st
Congress, 3d Session), especially the inserts at p. 878 thereof. For graphic
and other presentation of the effects of pyramiding in the public-utility
field see Utility Corporations (Sen. Doc. 92, 70th Congress, 1st Session,
pt. 72-A), pp. 154-166.

The most notorious pyramided structure of recent years was the Insull
set-up. An interesting example of a different type is presented by the
United States and Foreign Securities Corporation—United States and
International Securities Corporation relationship. These two situations
are briefly described in Note 64 at p. 803 of the Appendix.

659

660

SECURITY ANALYSIS

1916. It consisted of the purchase from the New York Central
Railroad Company, for the sum of $8,500,000, of common and
preferred stock constituting control of the New York, Chicago,
and St. Louis Railroad Company (known as the “Nickel Plate”).
This purchase was financed by giving a note to the seller for
$6,500,000 and by a cash payment of $2,000,000, which in turn
was borrowed from a Cleveland bank. Subsequent acquisitions
of control of many other companies were effected by various
means, including the following:

1. The formation of a private corporation for the purpose ( e.g., Western
Corporation to acquire control of Lake Erie and Western Railroad Company,
and Clover Leaf Corporation to acquire control of Toledo, St. Louis and
Western Railroad Company—both in 1922).

2. The use of the resources of one controlled railroad to acquire control of
others (e.g., the New York, Chicago and St. Louis Railroad Company pur¬
chased large amounts of stock of Chesapeake and Ohio Railway and Pere
Marquette Railway Company during 1923-1925).

3. The formation of a holding company to control an individual road, with
sale of the holding company's securities to the public (e.g., Chesapeake
Corporation, which took over control of Chesapeake and Ohio Railway
Company and sold its own bonds and stock to the public, in 1927).

4. Formation of a general holding company (e.g. Alleghany Corporation,
chartered in 1929. This ambitious project took over control of many
railroad, coal, and miscellaneous enterprises).

The report on the “Van Sweringen Holding Companies” made
to the House of Representatives in 1930 1 includes an interesting
chart showing the contrast between the control exercised by
the Van Sweringens and their relatively small equity or financial
interest in the capital of the enterprises controlled. On page 661
we append a summary of these data. The figures in Column A
show the percentage of voting securities held or controlled by the
Van Sweringens; the figures in Column B show the proportion of
the “contributed capital” (bonds, stock, and surplus) actually
owned directly or indirectly by them.

It is worth recalling that similar use of the holding company
for pyramiding control of railroad properties had been made
before the war—notably in the case of the Rock Island Company.
This enterprise was organized in 1902. Through an intermediate
subsidiary it acquired nearly all the common stock of the Chicago,
Rock Island and Pacific Railway Company and about 60% of

1 House Report 2789, 71st Congress, 3d Session, Part 2, pp. 820-1173.

OTHER ASPECTS OF SECURITY ANALYSIS

661

the capital stock of the St. Louis and San Francisco Railway Com¬
pany. Against these shares the two holding companies issued
large amounts of collateral trust bonds, preferred stock and com¬
mon stock. In 1909 the stock of the St. Louis and San Francisco
was sold. In 1915 the Rock Island Company and its inter¬
mediate subsidiary both went into bankruptcy; the stock of the
operating company was taken over by the collateral trust bond¬
holders; and the holding company stock issues were wiped out
completely.

Companies

A. Con¬
trol, %

B . Equity,

Holding companies:

The Vaness Co.

80.0

27.7

General Securities Corp.

90.0

51.8

Geneva Corp.

100.0

27.7

Alleghany Corp.

41.8

8.6

The Chesapeake Corp.

71.0

4.1

The Pere Marquette Corp.

100.0

0.7

Virginia Transportation Corp.

100.0

0.8

The Pittston Co.

81.8

4.3

Railroad Companies:

The New York, Chicago and St. Louis
R.R. Co.

49.6

0.7

The Chesapeake and Ohio Railway Co.

54.4

1.0

Pere Marquette Railway Co.

48.3

0.6

Erie Railroad Co.

30.8

0.6

Missouri Pacific Railroad Co.

50.5 i

1.7

The Hocking Valley Railway Co.

81.0

0 2

The Wheeling and Lake Eric Railway Co.

53.3

0.3

Kansas City Southern Railway Co.

20.8

0.9

The ignominious collapse of this venture was accepted at the
time as marking the end of “high finance” in the railroad field.
Yet some ten years later the same unsound practices were
introduced once again, but on a larger scale and with correspond¬
ingly severer losses to investors. It remains to add that the
Congressional investigation of railroad holding companies
instituted in 1930 had its counterpart in a similar inquiry into
the finances of the Rock Island Company made by the Interstate
Commerce Commission in 1914. The memory of the financial
community is proverbially and distressingly short.

662

SECURITY ANALYSIS

Evils of Corporate Pyramiding.—The pyramiding device is
harmful to the security-buying public from several standpoints.
It results in the creation and sale to investors of large amounts
of unsound senior securities. It produces common stocks of
holding companies which are subject to deceptively rapid
increases in earning power in favorable years and which are
invariably made the vehicle of wild and disastrous public specu¬
lation. The possession of control by those who have no real
capital investment (or a relatively minor one) is inequitable 1 and
makes for irresponsible and unsound managerial policies.
Finally the holding company device permits of financial practices
that exaggerate the indicated earnings, dividend return, or “book
value,” during boom times, and thus intensify speculative fervor
and facilitate market manipulation. Of these four objections to
corporate pyramiding, the first three are plainly evident, but the
last one requires a certain amount of analytical treatment in
order to present its various implications.

Overstatement of Earnings .—Holding companies can overstate
their apparent earning power by valuing at an unduly high
price the stock dividends they receive from subsidiaries or by
including in their income profits made from the sale of stock
of subsidiary companies.

Examples: The chief asset of Central States Electric Corpora¬
tion was a large block of North American Company common
on which regular stock dividends were paid. Prior to the end
of 1929, these stock dividends were reported as income by Central
States at the market value then current. As explained in our
chapter on stock dividends, such market prices averaged far in
excess of the value at which North American charged the stock
dividends against its surplus and also far in excess of the distribut¬
able earnings on North American common. Hence the income
account of Central States Electric gave a misleading impression
of the earnings accruing to the company.

A transaction of somewhat different character but of similar
effect to the foregoing was disclosed by the report of American
Founders Trust for 1927. In November 1927 American Found¬
ers offered its shareholders the privilege of buying about 88,400
shares of International Securities Corporation of America Class
B Common at $16 per share. International Securities Corpora-

1 See Appendix Note 65, p. 806, for examples on this point.

OTHER ASPECTS OF SECURITY ANALYSIS

663

tion was a subsidiary of American Founders, and the latter had
acquired the Class B stock of the former at a cash cost of $3.70
per share in 1926. American Founders reported net earnings
for common stock in 1927 amounting to $1,316,488, most of
which was created by its own stockholders through their pur¬
chase of shares of the subsidiary as indicated above. 1

Distortion of Dividend Return .—Just as a holding company's
income may be exaggerated by reason of stock dividends received,
so the dividend return on its shares may be distorted in the
public's mind by payment of periodic stock dividends with a
market value exceeding current earnings. People are readily
persuaded also to regard the value of frequent subscription rights
as equivalent to an income return on the common stock. Pyra¬
mided enterprises are prodigal with subscription rights, for they
flow naturally from the succession of new acquisitions and new
financing which both promote the ambitions of those in control
and maintain speculative interest at fever heat—until the
inevitable collapse.

The issuance of subscription rights sometimes gives the stock
market an opportunity to indulge in that peculiar circular
reasoning which is the joy of the manipulator and the despair
of the analyst. Company A ’s stock is apparently worth no more
than 25. Speculation or pool activity has advanced it to 75.
Rights are offered to buy additional shares at 25, and the rights
have a market value of, say, $10 each. To the speculative
fraternity these rights are practically equivalent to a special
dividend of $10. It is a bonus that not only justifies the rise
to 75 but warrants more optimism and a still higher price. To
the analyst the whole proceeding is a delusion and a snare.
Whatever value the rights command is manufactured solely
out of speculators' misguided enthusiasm, yet this chimerical
^alue is accepted as tangible income and as vindication of the
enthusiasm that gave it birth. Thus, with the encouragement
of the manipulator, the speculative public pulls itself up by its
bootstraps to dizzier heights of irrationality.

1 In the three years 1928-1930 the American Founders group reported
total net investment profits of about $43,300,000; but all of this sum and
more was derived from profits on intercompany transactions of the kind
described above. See the S.E.C.’s Over-all Report on Investment Trusts,
Part III, Chapter VI, Sections II and III, released February 12, 1940.

664

SECURITY ANALYSIS

Example: Between August 1928 and February 1929 American
and Foreign Power Company common stock advanced from 33
to 138%, although paying no dividend. Rights were offered to
the common stockholders (and other security holders) to buy
second preferred stock with detached stock-purchase warrants.
The offering of these rights, which had an initial market value of
about $3 each, was construed by many as the equivalent of a
dividend on the common stock.

Exaggeration of Book Value .—The exaggeration of book value
may be effected in cases where a holding company owns most
of the shares of a subsidiary and where consequently an arti¬
ficially high quotation may readily be established for the subsid¬
iary issue by manipulating the small amount of stock remaining
in the market. This high quotation is then taken as the basis
of figuring the book value (sometimes called the “ break-up
value”) of the share of the holding company. For an early
example of these practices we may point to Tobacco Products
Corporation (Va.) which owned about 80% of the common stock
of United Cigar Stores Company of America. An unduly high
market price seems to have been established in 1927 for the small
amount of Cigar Stores stock available in the market, and this
high price was used to make Tobacco Products shares appear
attractive to the unwary buyer. The thoroughly objectionable
accounting and stock dividend policies of United Cigar Stores,
which we have previously discussed, were adjuncts to this
manipulative campaign.

The most extraordinary example of such exaggeration of the
book value is found, perhaps, in the case of Electric Bond and
Share Company and was founded on its ownership of most
of the American and Foreign Power Company warrants. The
whole set-up seems to have been contrived to induce the public
to pay absolutely fantastic prices without their complete absurd¬
ity being too apparent. A brief review of the various steps
in this phantasmagoria of inflated values should be illuminating
to the student of security analysis.

First, American and Foreign Power Company issued in all
1,600,000 shares of common and warrants to buy 7,100,000 more
shares at $25. This permitted a price to be established for
the common stock that generously capitalized its earnings and
prospects but paid no attention to the existence of the warrants.

OTHER ASPECTS OF SECURITY ANALYSIS 665

The quotation of the common was aided by the issuance of
rights, as explained above.

Second, the high price registered for the relatively small com¬
mon-stock issue automatically created a correspondingly high
value for the millions of warrants.

Third, Electric Bond and Share could apply these high values
to its large holdings of American and Foreign Power common
and its enormous block of warrants, thus setting up a corre¬
spondingly inflated value for its own common stock.

Exploitation of the Stock-purchase-warrant Device .—The result
of this process, at its farthest point in 1929, was almost incredible.
The earnings available for American and Foreign Power common
stock had shown the following rising trend (due in good part,
however, to continuous new acquisitions):

Year

Earnings for
common

Number of shares

Earned per share

1926

$ 216,000

1,243,988

0 17

1927

856,000

1,244,388

1928

1,528,000

1,248,930

1.22

1929

6,510,000

1,624,357

4.01

On the theory that a “good public-utility stock is worth up
to 50 times its current earnings,'” a price of 199)4 per share was
recorded for American and Foreign Power common. This
produced in turn a price of 174 for the warrants. Hence, by
the insane magic of Wall Street, earnings of $6,500,000 were
transmuted into a market value of $320,000,000 for the common
shares and $1,240,000,000 for the warrants, a staggering total of
$1,560,000,000.

Since over 80% of the warrants were owned by Electric Bond
and Share Company, the effect of these absurd prices for Amer¬
ican and Foreign Power junior securities was to establish a
correspondingly absurd break-up value for Electric Bond and
Share common. This break-up value was industriously exploited
to justify higher and higher quotations for the latter issue. In
March 1929 attention was called to the fact that the market value
of this company’s portfolio was equivalent to about $108 per
share (of new stock), against a range of 91 to 97 for its own
market quotation. The implication was that Electric Bond and

666

SECURITY ANALYSIS

Share stock was “undervalued.” In September 1929 the price
had advanced to 18434- It was then computed that the
“ break-up value” amounted to about 150, “ allowing no value for
the company’s supervisory and construction business.” The
public did not stop to reflect that a considerable part of this
“book value” was based upon an essentially fictitious market
quotation for an asset that the company had received for nothing
only a few years before (as a bonus with American and Foreign
Power Second Preferred stock).

This exploitation of the warrants had a peculiar vitality which
made itself felt even in the depth of the depression in 1932-1933.
Time having brought its usual revenge, the once dazzling Amer¬
ican and Foreign Power Company had trembled on the brink
of receivership, as shown by a price of only 1534 for its 5%
bonds. Nevertheless, in November 1933 the highly unsubstan¬
tial warrants still commanded an aggregate market quotation
of nearly $50,000,000, a figure that bore a ridiculous relationship
to the exceedingly low values placed upon the senior securities.
The following table shows how absurd this situation was, the
more so since it existed in a time of deflated stock prices, when
relative values are presumably subjected to more critical
appraisal.

(000 omitted in market value)

Issue

Amount

out¬

stand¬

ing

Price

Nov.

1933

Total

market

value,

1933

Price
Dec. 31,
1938

Total

market

value,

1938

5 % Debentures...

$50,000

26,500

$7 First Preferred

. shares

19 %

9,300

$6 First Preferred

. .shares

5,800

$7 Second Preferred

. .shares

2,655

tmsitii]

24,900

Common .

. .shares

1,850

18,500

6,500

Warrants.

..shares

6,874

*48,100

6,900

By the end of 1938, as the table indicates, a good part of the
absurdity had been corrected.

Some Holding Companies Not Guilty of Excessive Pyramid¬
ing. —To avoid creating a false impression, we must point out
that, although pyramiding is usually effected by means of holding

OTHER ASPECTS OF SECURITY ANALYSIS 667

companies, it does not follow that all holding companies are
created for this purpose and are therefore reprehensible. The
holding company is often utilized for entirely legitimate pur¬
poses, e.g. } to permit unified and economical operations of
separate units, to diversify investment and risk and to gain
certain technical advantages of flexibility and convenience.
Many sound and important enterprises are in holding company
form.

Examples: United States Steel Corporation is entirely a holding
company; although originally there was some element of pyramid¬
ing in its capital set-up, this defect disappeared in later years.
American Telephone and Telegraph Company is preponderantly
a holding company, but its financial structure has never been
subject to serious criticism. General Motors Corporation is
largely a holding company.

A holding-company exhibit must therefore be considered on its
merits. American Light and Traction Company is a typical
example of the holding company organized entirely for legitimate
purposes. On the other hand the acquisition of control of this
enterprise by United Light and Railways Company (Del.) must
be regarded as a pyramiding move on the part of the United Light
and Power interests.

Speculative Capital Structure May Be Created in Other Ways.

It may be pointed out also that a speculative capital structure
can be created without the use of a holding company.

Examples: The Maytag Company recapitalization, discussed
in an earlier chapter, yielded results usually attained by the
formation of a holding company and the sale of its senior securi¬
ties. In the case of Continental Baking Corporation—to cite
another example—the holding company form was not an essential
part of the pyramided result there attained. The speculative
structure was due entirely to the creation of large preferred
issues by the parent company, and it would still have existed if
Continental Baking had acquired all its properties directly,
eliminating its subsidiaries. (As it happened, in 1938 this com¬
pany took steps to acquire the assets of its chief subsidiaries, thus
largely eliminating the holding-company form but retaining the
speculative capital structure.)

Legislative Restraints on Pyramiding.— So spectacular were
the disastrous effects of the public-utility pyramiding of the

668

SECURITY ANALYSIS

1920’s that Congress was moved to drastic action. The Public
Utility Holding Company Act of 1936 includes the so-called
“death sentence” for many of the existing systems, requiring
them ultimately to simplify their capital structures and to dispose
of subsidiaries operating in noncontiguous territory. Formation
of new pyramids is effectively blocked by requiring Commission
approval for all acquisitions and all new financing. Similar
steps are in prospect to regulate present railroad holding com¬
panies and to prevent creation of new ones. 1

We may say with some confidence that the spectacle of the
Van Sweringen debacle succeeding the Rock Island Company
debacle is not likely to be duplicated in the future. The indus¬
trial field never offered the same romantic possibilities for high
finance as were found among the rails and utilities, but it may well
be that the ingenious talents of promoters and financial wizards
will be directed towards the industrials in the future. The
investor and the analyst should be on their guard against such
new dazzlements.

1 See Senate Resolution 71 of the 74th Congress and 21 volumes of hearings
thereon which have appeared to date (December 1939). Sec also Senate
Report No. 180, 75th Congress, 1st Session, and Senate Report No. 25,
pts. 1, 4 and 5, 76th Congress, 1st Session.

CHAPTER XLIX

COMPARATIVE ANALYSIS OF COMPANIES IN THE
SAME FIELD

Statistical comparisons of groups of concerns operating in a
given industry are a more or less routine part of the analyst’s
work. Such tabulations permit each company’s showing to be
studied against a background of the industry as a whole. They
frequently bring to light instances of undervaluation or over¬
valuation or lead to the conclusion that the securities of one
enterprise should be replaced by those of another in the same
field.

In this chapter we shall suggest standard forms for such com¬
parative analyses, and we shall also discuss the significance of the
various items included therein. Needless to say, these forms are
called “standard” only in the sense that they can be used gen¬
erally to good advantage; no claim of perfection is made for
them, and the student is free to make any changes that he thinks
will serve his particular purpose.

FORM I. RAILROAD COMPARISON

A. Capitalization:

1. Fixed charges. 1

2. Effective debt (fixed charges 1 multiplied by 22).

3. Preferred stock at market (number of shares X market price).

4. Common stock at market (number of shares X market price).

6. Total capitalization.

6. Ratio of effective debt to total capitalization.

7. Ratio of preferred stock to total capitalization.

8. Ratio of common stock to total capitalization.

B . Income Account:

9. Gross revenues.

10. Ratio of maintenance to gross.

11. Ratio of railway operating income (net after taxes) to gross.

12. Ratio of fixed charges 1 to gross.

1 Or net deductions if larger.

669

670

SECURITY ANALYSIS

13. Ratio of preferred dividends to gross.

14. Ratio of balance for common to gross.

C. Calculations:

15. Number of times fixed charges 1 earned.

15. I.P. 2 Number of times fixed charges 1 plus preferred dividends
earned.

16. Earned on common stock, per share.

17. Earned on common stock, % of market price.

18. Ratio of gross to aggregate market value of common stock (9 -*-4).

16. S.P. 3 Earned on preferred stock, per share.

17. S.P. Earned on preferred stock, % of market price.

18. S.P. Ratio of gross to aggregate market value of preferred stock
(9 + 3).

19. Credit or debit to earnings for undistributed profit or loss of sub¬
sidiaries (if important).

D. Seven-year average figures:

20. Earned on common stock, per share.

21. Earned on common stock, % of current market price of common.

20. S.P. Earned on preferred stock, per share.

21. S.P. Earned on preferred stock, % of current market price of
preferred.

22. Number of times net deductions earned.

23. Number of times fixed charges earned.

22. I.P. Number of times net deductions plus preferred dividends
earned.

23. I.P. Number of times fixed charges plus preferred dividends earned.

E . Trend figure:

24 to 30. Earned per share on common stock each year for past seven
years. (Where necessary, earnings should be adjusted to present
capitalization.)

24. S.P. to 30. S.P. Same data for speculative preferred stock, if
wanted.

F. Dividends:

31. Dividend rate on common.

32. Dividend yield on common.

31. P. Dividend rate on preferred.

32. P. Dividend yield on preferred.

1 Or net deductions if larger.

1 I.P. = for studying an investment preferred stock.

• S.P. « for studying a speculative preferred stock.

Observations on the Railroad Comparison. 1 —It has formerly-
been the custom to base earnings studies on the figures for the
1 Reference is made to earlier chapters for explanation of the terminology
and the critical tests referred to in this discussion.

OTHER ASPECTS OF SECURITY ANALYSIS

671

previous calendar years, with certain references to later interim
reports. But since complete figures are now available month
by month, it is more logical and effective practice to ignore the
calendar-year division and to use instead the results for the twelve
months to the latest date available. The simplest way to arrive
at such a twelve months’ figure is to apply the change shown for
the current year to date to the results of the previous calendar
year.

Example:

Gross Earnings of Pennsylvania Railroad System for 12 Months

Ended June, 1939

(1) 6 months to June 1939 (as reported) $189,623,000

(2) 6 months to June 1938 (as reported) 167,524,000

(3) Difference. + 22,099,000

(4) Calendar year 1938. 360,384,000

12 months to June 1939 (4 plus 3) . $382,483,000

Our table includes a few significant calculations based on the
seven-year average. In an intensive study, average results
should be scrutinized in more detail. To save time, it is sug¬
gested that additional average figures be computed only for
those roads which the analyst selects for further investigation
after he has studied the exhibits in the “standard form.”
Whether the period of averaging should cover seven years or
a longer or shorter time is largely a matter for individual judg¬
ment. In theory it should be just long enough to cover a full
cyclical fluctuation but not so long as to include factors or results
that are totally out of date. The six years 1934-1939 might
well be regarded as a somewhat better criterion, for example,
than the longer period 1933-1939.

Figures relating to preferred stocks fall into two different
classes, depending on whether the issue is considered for fixed-
value investment or as a speculative commitment. (Usually
the market price will indicate clearly enough in which category
a particular issue belongs.) The items marked “I.P.” are to
be used in studying an investment preferred stock, and those
marked “S.P.” in studying a speculative preferred. Where
there are junior income bonds, the simplest and most satisfactory
procedure will be to treat them in all respects as a preferred
stock issue, with a footnote referring to their actual title. Such

672

SECURITY ANALYSIS

contingent bond interest will therefore be excluded from the
net deductions or the fixed charges.

In this tabular comparison we follow the suggestion previously
offered that the effective debt be computed by capitalizing the
larger of net deductions or fixed charges. In using the table as
an aid to the selection of senior issues for investment, chief
attention will be paid to items 22 and 23 (or 22 “I.P.” and 23
“I.P.”), showing the average margin above interest (and pre¬
ferred dividend) requirements. Consideration should be given
also to items 6, 7 and 8, showing the division of total capitaliza¬
tion between senior securities and junior equity. (In dealing
with bonds, the preferred stock is part of the junior equity;
in considering a preferred stock for investment, it must be
included with the effective debt.) Items 10 and 19 should also
be examined to see if the earnings have been overstated by
reason of inadequate maintenance or by the inclusion of unearned
dividends from subsidiaries.

Speculative preferred stocks will ordinarily be analyzed in
much the same way as common stocks, and the similarity
becomes greater as the price of the preferred stock is lower.
It should be remembered, however, that a preferred stock is
always less attractive, logically considered, than a common
stock making the same showing. For example, a $6 preferred
earning $5 per share is intrinsically less desirable than a common
stock earning $5 per share (and with the same prior charges),
since the latter is entitled to all the present and future equity,
whereas the preferred stock is strictly limited in its claim upon
the future.

In comparing railroad common stocks (and preferred shares
equivalent thereto), the point of departure is the percentage
earned on the market price. This may be qualified, to an extent
more or less important, by consideration of items 10 and 19.
Items 12 and 18 will indicate at once whether the company is
speculatively or conservatively capitalized, relatively speaking.
A speculatively capitalized road will show a large ratio of net
deductions to gross and (ordinarily) a small ratio of common
stock at market value to gross. The converse will be true for a
conservatively capitalized road.

Limitation upon Comparison of Speculatively and Conserva¬
tively Capitalized Companies in the Same Field.—The analyst

OTHER ASPECTS OF SECURITY ANALYSIS

673

must beware of trying to draw conclusions as to the relative
attractiveness of two railroad common stocks when one is
speculatively and the other is conservatively capitalized. Two
such issues will respond quite differently to changes for the better
or the worse, so that an advantage possessed by one of them under
current conditions may readily be lost if conditions should change.

Example: The example shown below illustrates in a twofold
fashion the fallacy of comparing a conservatively capital¬
ized with a speculatively capitalized common stock. In 1922
the earnings of Union Pacific common were nearly four times

Comparison op Union Pacific and Rock Island Common Stocks

Union Chicago,

Item Pacific Rock Island,

R.R. & Pacific Ry.

A. Showing the effect of general improvement:

Average price of common, 1922. 140 40

Earned per share, 1922. $12.76 $0.96

% earned on market price, 1922. 9.1% 2.4%

Fixed charges and preferred dividends earned,

1922. 2.39 times 1.05 times

Ratio of gross to market value of common,

1922. 62% 419%

Increase in gross, 1927 over 1922. 5.7% 12.9%

Earned per share of common, 1927. $16.05 $12.08

Increase in earnings on common, 1927 over

1922. 26% 1,158%

Average price of common, 1927. 179 92

Increase in average price, 1927 over 1922. ... 28% 130%

B. Showing the effect of a general decline in

business:

Earned on average price, 1927. 9.0% 13.1%

Fixed charges and preferred dividends earned,

1927. 2.64 times 1.58 times

Ratio of gross to market value of common,

1927. 51% 204%

Decrease in gross, 1933 below 1927. 46% 54%

Earned on common, 1933. $7.88 % 20 . 40 (d)

Decrease in earnings for common, 1933 below

1927. 51% 269%

Average price of common, 1933. 97 6

Decrease in average price, 1933 below 1927... 46% 93%

Notb: In June 1933 trustees in bankruptcy were appointed for the Rock Island.

674

SECURITY ANALYSIS

as high in relation to market price as were those of Rock Island
common. A conclusion that Union Pacific was “ cheaper,”
based on these figures, would have been fallacious, because the
relative capitalization structures were so different as to make the
two companies noncomparable. This fact is shown graphically
by the much larger expansion of the earnings and the market price
of Rock Island common that accompanied the moderate rise
in gross business during the five years following.

The situation in 1927 was substantially the opposite. At
that time Rock Island common was earning proportionately
more than Union Pacific common. But it would have been
equally fallacious to conclude that Rock Island common was
“ intrinsically cheaper.” The speculative capitalization struc¬
ture of the latter road made it highly vulnerable to unfavorable
developments, so that it was unable to withstand the post-1929
depression.

Other Illustrations in Appendix. —The practical approach to
comparative analysis of railroad stocks (and bonds) may best
be illustrated by the reproduction of several such comparisons
made by one of the authors a number of years ago and published
as part of the service rendered to clients by a New York Stock
Exchange firm. These will be found in the Appendix, Note 66.
It will be observed that the comparisons were made between
roads in approximately the same class as regards capitalization
structure, with the exception of the comparison between Atchison
and New York Central, in which instance special reference was
made to the greater sensitivity of New York Central to changes
in either direction.

FORM n. PUBLIC-UTILITY COMPARISON

The public-utility comparison form is practically the same
as that for railroads. The only changes are the following:
Fixed charges (as mentioned in line 1 and elsewhere) should
include subsidiary-preferred dividends. Line 2 should be called
“Funded debt and subsidiary preferred stock,” and these should
be taken from the balance sheet. Items 22 and 22 I.P., relating
to net deductions, are not needed. Item 10 becomes “ratio of
depreciation to gross.” An item, 10M, may be included to show
“ratio of maintenance to gross” for the companies which publish
this information.

OTHER ASPECTS OF SECURITY ANALYSIS

675

Our observations regarding the use of the railroad comparison
apply as well to the public-utility comparison. Variations
in the depreciation rate are fully as important as variations
in the railroad maintenance * ratios. When a wide difference
appears, it should not be taken for granted that one property
is unduly conservative or the other not conservative enough,
but a 'presumption to this effect does arise, and the question should
be investigated as thoroughly as possible. A statistical indica¬
tion that one utility stock is more attractive than another should
not be acted upon until (among other qualitative matters)
some study has been made of the rate situation and the relative
prospects for favorable or unfavorable changes therein. In
view of experience since 1933, careful attention should also be
given to the dangers of municipal or federal competition.

FORM HI. INDUSTRIAL COMPARISON (FOR COMPANIES IN THE

SAME FIELD)

Since this form differs in numerous respects from the two
preceding, it is given in full herewith:

A. Capitalization:

1. Bonds at par.

2. Preferred stock at market value (number of shares X market price).

3. Common stock at market value (number of shares X market price).

4. Total capitalization.

5. Ratio of bonds to capitalization.

6. Ratio of aggregate market value of preferred to capitalization.

7. Ratio of aggregate market value of common to capitalization.

B. Income Account (most recent year).

8. Gross sales.

9. Depreciation.

10. Net available for bond interest.

11. Bond interest.

12. Preferred dividend requirements.

13. Balance for common.

14. Margin of profit (ratio of 10 to 8).

15. % earned on total capitalization (ratio of 10 to 4).

C. Calculations.

16. Number of times interest charges earned.

16. I.P. Number of times interest charges plus preferred dividends
earned.

676

SECURITY ANALYSIS

17. Earned on common, per share.

18. Earned on common, % of market price.

17. S.P. Earned on preferred, per share.

18. S.P. Earned on preferred, % of market price.

19. Ratio of gross to aggregate market value of common.

19. S.P. Ratio of gross to aggregate market value of preferred.

D. Seven-year average:

20. Number of times interest charges earned.

21. Earned on common stock per share.

22. Earned on common stock, % of current market price.

(20 I.P., 21 S.P. and 22 S.P.—Same calculation for preferred stock if
wanted).

E. Trend figure:

23. Earned per share of common stock each year for past seven years
(adjustments in number of shares outstanding to be made where
necessary).

23. S.P. Same data for speculative preferred issues, if wanted.

F . Dividends:

24. Dividend rate on common.

25. Dividend yield on common.

24. P. Dividend rate on preferred.

25. P. Dividend yield on preferred.

G. Balance sheet:

26. Cash assets.

27. Receivables (less reserves).

28. Inventories (less proper reserves).

29. Total current assets.

30. Total current liabilities.

30. N. Notes Payable (Including “ Bank Loans” and “Bills Payable”).

31. Net current assets.

32. Ratio of current assets to current liabilities.

33. Ratio of inventory to sales.

34. Ratio of receivables to sales.

35. Net tangible assets available for total capitalization.

36. Cash-asset-value of common per share (deducting all prior obli¬
gations).

37. Net-current-asset-value of common per share (deducting all prior
obligations).

38. Net-tangible-asset-value of common per share (deducting all prior
obligations).

(36 S.P., 37 S.P., 38 S.P.—Same data for speculative preferred issues, if
wanted).

OTHER ASPECTS OF SECURITY ANALYSIS

677

H. Supplementary data (when available):

1. Physical output:

Number of units; receipts per unit; cost per unit; profit per unit;
total capitalization per unit.; common stock valuation per unit.

2. Miscellaneous:

For example: number of stores operated; sales per store; profit
per store; ore reserves; life of mine at current (or average) rate of
production.

Observations on the Industrial Comparison,—Some remarks
regarding the use of this suggested form may be helpful. The net
earnings figure must be corrected for any known distortions or
omissions, including adjustments for undistributed earnings or
losses of subsidiaries. If it appears to be misleading and cannot
be adequately corrected, it should not be used as a basis of com¬
parisons. (Inferences drawn from unreliable figures must them¬
selves be unreliable.) No attempt should be made to subject
the depreciation figures to exact comparisons; they are useful
only in disclosing wide and obvious disparities in the rates used.
The calculation of bond-interest-coverage is subject to the
qualification discussed in Chap. XVII, with respect to companies
that may have important rental obligations equivalent to interest
charges.

Whereas the percentage earned on the market price of the
common (item 18) is a leading figure in all comparisons, almost
equal attention must be given to item 15, showing the percentage
earned on total capitalization. These figures, together with
items 7 and 19 (ratio of aggregate market value of common stock
to sales and to capitalization), will indicate the part played
by conservative or speculative capitalization structures among
the companies compared. (The theory of capitalization struc¬
ture was considered in Chap. XL.)

As a matter of practical procedure it is not safe to rely upon
the fact that the earnings ratio for the common stock (item 18) is
higher than the average for the industry, unless the percentage
earned on the total capitalization (item 15) is also higher. Fur¬
thermore, if the company with the poorer earnings exhibit shows
much larger sales-per-dollar-of-common-stock (item 19), it may
have better speculative possibilities in the event of general busi¬
ness improvement.

678

SECURITY ANALYSIS

The balance-sheet computations do not have primary sig¬
nificance unless they indicate either definite financial weakness
or a substantial excess of current-asset-value over the market
price. The division of importance as between the current
results, the seven-year average and the trend is something
entirely for the analyst's judgment to decide. Naturally, he
will have the more confidence in any suggested conclusion if
it is confirmed on each of these counts.

Example of the Use of Standard Forms. —An example of the
use of the standard form to reach a conclusion concerning com¬
parative values should be of interest. A survey of the common
stocks of the listed steel producers in July 1938 indicated that
Continental Steel had made a better exhibit than the average,
whereas Granite City Steel had shown much smaller earning
power. The two companies operated to some extent in the same
branches of the steel industry; they were very similar in size, and
the price of their common stocks was identical. In the tabulation
presented on page 680 we supply comparative figures for these
two enterprises, omitting some of the items on our standard
form as immaterial to this analysis.

Comments on the Comparison .—The use of five-year average
figures for each item, presented along with those of the most
recent twelve months, is suggested here because the subnormal
business conditions in the year ended June 30, 1938 made it
inadvisable to lay too great emphasis on the results for this single
period. Granite City reports on calendar-year basis, whereas
Continental used both a June 30 and a December 31 fiscal year
during 1934-1938. However, the availability of quarterly or
semiannual figures makes it a simple matter for the analyst to
construct his average and 12 months' figures to end in the middle
of the year.

Analysis of the data reveals only one point of superiority for
Granite City Steel—the smaller amount of senior securities. But
even this is not necessarily an advantage, since the relatively
fewer shares of Continental common make them more sensitive
to favorable as well as unfavorable developments. The exhibit
for the June 1938 year, and five-year average, show a statistical
superiority for Continental on each of the following important
points:

OTHER ASPECTS OF SECURITY ANALYSIS

679

Earnings on market price of common stock.

Earnings on total capitalization.

Ratio of gross to market value of common.

Margin of profit.

Depreciation in relation to plant Account.

Working-capital position.

Tangible asset values.

Dividend return.

Trend of earnings.

If the comparison is carried back prior to 1934, Granite City
is found to have enjoyed a marked advantage in the depression
years from mid-1930 to mid-1933. During this time it earned
and paid dividends while Continental Steel was reporting mod¬
erate losses. It is curious to observe that in the more recent
recession the tables were exactly turned, and Continental Steel
did very well while Granite City fared badly. Obviously the
1937-1938 results would command more attention than those
in the longer past. Nevertheless, the thorough analyst would
endeavor to learn as much as possible about the basic reasons
underlying the change in the relative performance of the two
companies.

Study of Qualitative Factors Also Necessary.—Our last obser¬
vation leads to the more general remark that conclusions sug¬
gested by comparative tabulations of this sort should not be
accepted until careful thought has been given to the qualitative
factors. When one issue seems to be selling much too low on the
basis of the exhibit in relation to that of another in the same
field, there may be adequate reasons for this disparity that the
statistics do not disclose. Among such valid reasons may be a
definitely poorer outlook or a questionable management. A
lower dividend return for a common stock should not ordinarily
be considered as a strong offsetting factor, since the dividend is
usually adjusted to the earning power within a reasonable time.

Although overconservative dividend policies are sometimes
followed for a considerable period (a subject referred to in
Chap. XXIX), there is a well-defined tendency even in these
cases for the market price to reflect the earning power sooner or
later.

Relative popularity and relative market activity are two
elements not connected with intrinsic value that nevertheless

680

SECURITY ANALYSIS

exert a powerful and often a continuing effect upon the market
quotation. The analyst must give these factors respectful
heed, but his work would be stultified if he always favored the
more active and the more popular issue.

Comparison op Continental Steel and Granite City Steel

(000 omitted, except those per share)

Item

Market price of common, July 1938.

1. Bonds at par.

2. Preferred stock at market.

3. Common stock at market.

4. Total capitalisation.

5. Ratio of common to total capitali¬

zation.

8. Gross sales.

9. Depreciation.

10. Net available for bond interest...

11. Bond interest.

12. Preferred dividends.

13. Balance for common.

14. Margin of profit.

15. % earned on total capitalization. .

16. Interest charges earned .

17. Earned on common, per sharo

18. Earned on common, % of market

price.

19. Ratio of gross to market value of

common.

Trend figures:

23. Earned per share by years:

Year ended June 30, 1938 .

Year ended June 30, 1937.

Year ended June 30, 1936
Year ended June 30, 1935
Year ended June 30, 1934..
Dividends:

24. Dividend rate on common.

25. Dividend yield on common.
Financial position (dates):

29. Total current assets.

30. Total current liabilities.

31. Net current assets.

35. Net tangible assets for total capital¬
ization .

Continental Steel

Granite City Steel

$1,202

$1,618

450

3,410

6,494

7,062

8,112

48.3%

80.0%

Average of
5 years
ended
C/30/38

Year

ended

6/30/38

Average of
5 years
ended
6/30/38

Year

ended

6/30/38

$15,049

$13,989

$8,715

$8,554

500

445

390

459

704

559

336

887(d)

(Est.) 18

(Est.) 54

179

171

444

321

318

341(d)

4 7%

4.0%

3.9%

( def .)

10.0

7.9%

4 1%

(def.)

8.7 times

8.3 times

18 7 times

(def.)

$2.29

$1.60

$1.20

%0.89(d)

13.5

9.4

7.1

(d)

441.5%

409.8%

134.3%

131.8%

$1.60

$0.89(d)

3.83

1.31

2.67

1.49

1 69

1.45

1.C0

$1.00

2.05

None

5.9%

6/30/38

12/31/37

$ 6,467

$ 4,179

1,198

1,164

5,269

3,015

13,498

13,556

OTHER ASPECTS OF SECURITY ANALYSIS

681

The recommendation of an exchange of one security for
another seems to involve a greater personal accountability on
the part of the analyst than the selection of an issue for original
purchase. The reason is that -holders of securities for investment
are loath to make changes, and thus they are particularly irri¬
tated if the subsequent market action makes the move appear
to have been unwise. Speculative holders will naturally gage
all advice by the test of market results—usually immediate
results. Bearing these human-nature factors in mind, the
analyst must avoid suggesting common-stock exchanges to
speculators (except possibly if accompanied by an emphatic
disclaimer of responsibility for subsequent market action), and
he must hesitate to suggest such exchanges to holders for invest¬
ment unless the statistical superiority of the issue recommended
is quite impressive. As an arbitrary rule, we might say that
there should be good reason to believe that by making the
exchange the investor would be getting at least 50% more for
his money.

Variations in Homogeneity Affect the Values of Comparative
Analysis.—The dependability of industrial comparisons will vary
with the nature of the industry considered. The basic question,
of course, is whether future developments are likely to affect
all the companies in the group similarly or dissimilarly. If
similarly, then substantial weight may be accorded to the relative
performance in the past, as shown by the statistical exhibit. An
industrial group of this type may be called “homogeneous.”
But, if the individual companies in the field are likely to respond
quite variously to new conditions, then the relative showing
must be regarded as a much less reliable guide. A group of this
kind may be termed “heterogeneous.”

With certain exceptions for traffic and geographical variations,
e.g in particular, the Pocohantas soft-coal carriers, the railroads
must be considered a highly homogeneous group. The same is
true of the larger light, heat and power utilities. In the industrial
field the best examples of homogeneous groups are afforded by the
producers of raw materials and of other standardized products
in which the trade name is a minor factor. These would include
producers of sugar, coal, metals, steel products, cement, cotton
print cloths, etc. The larger oil companies may be considered
as fairly homogeneous; the smaller concerns are not well suited

682

SECURITY ANALYSIS

to comparison because they are subject to sudden important
changes in production, reserves and relative price received. The
larger baking, dairy and packing companies fall into fairly
homogeneous groups. The same is true of the larger chain-store
enterprises when compared with other units in the same sub¬
groups, e.g. t grocery, five-and-ten-cent, restaurant, etc. Depart¬
ment stores are less homogeneous, but comparisons in this field
are by no means far-fetched.

Makers of manufactured goods sold under advertised trade¬
marks must generally be regarded as belonging to heterogeneous
groups. In these fields one concern frequently prospers at the
expense of its competitors, so that the units in the industry
do not improve or decline together. Among automobile manu¬
facturers, for example, there have been continuous and pro¬
nounced variations in relative standing. Producers of all the
various classes of machinery and equipment are subject to some¬
what the same conditions. This is true also of the proprietary
drug manufacturers. Intermediate positions from this point of
view are occupied by such groups as the larger makers of tires,
of tobacco products, of shoes, wherein changes of relative position
are not so frequent. 1

The analyst must be most cautious about drawing compara¬
tive conclusions from the statistical data when dealing with
companies in a heterogeneous group. No doubt preference
may properly be accorded in these fields to the companies
making the best quantitative showing (if not offset by known
qualitative factors)—for this basis of selection would seem
sounder than any other—but the analyst and the investor
should be fully aware that such superiority may prove evanescent.
As a general rule, the less homogeneous the group the more
attention must be paid to the qualitative factors in making
comparisons.

More General Limitations on the Value of Comparative
Analysis. —It may be well once again to caution the student
against being deluded by the mathematical exactitude of his

1 But significant changes do occur, of course. Note, for example, the
phenomenal growth of Philip Morris, relative to its large competitors, the
somewhat less spectacular development of General Shoe and the exceptional
comparative showing of Lee Tire, in the three fields mentioned. AH three
of these were relatively small enterprises.

OTHER ASPECTS OF SECURITY ANALYSIS

683

comparative tables into believing that their indicated conclusions
are equally exact. We have mentioned the need of considering
qualitative factors and of allowing for lack of homogeneity. But
beyond these points lie all the’various obstacles to the success of
the analyst that we presented in some detail in our first chapter.
The technique of comparative analysis may lessen some of the
hazards of his work, but it can never exempt him from the
vicissitudes of the future or the stubborness of the stock market
itself or the consequences of his own failure—often unavoidable—
to learn all the important facts. He must expect to appear wrong
often and to be wrong on occasion; but with intelligence and
prudence his work should yield better over-all results than the
guesses or the superficial judgments of the typical stock buyer.

CHAPTER L

DISCREPANCIES BETWEEN PRICE AND VALUE

Our exposition of the technique of security analysis has
included many different examples of overvaluation and under¬
valuation. Evidently the processes by which the securities
market arrives at its appraisals are frequently illogical and
erroneous. These processes, as we pointed out in our first
chapter, are not automatic or mechanical but psychological, for
they go on in the minds of people who buy or sell. The mistakes
of the market are thus the mistakes of groups or masses of
individuals. Most of them can be traced to one or more of
three basic causes: exaggeration, oversimplification or neglect.

In this chapter and the next we shall attempt a concise review
of the various aberrations of the securities market. We shall
approach the subject from the standpoint of the practical activ¬
ities of the analyst, seeking in each case to determine the
extent to which it offers an opportunity for profitable action
on his part. This inquiry will thus constitute an amplification
of our early chapter on the scope and limitations of security
analysis, drawing upon the material developed in the succeeding
discussions, to which a number of references will be made.

General Procedure of the Analyst.—Since we have emphasized
that analysis will lead to a positive conclusion only in the excep¬
tional case, it follows that many securities must be examined
before one is found that has real possibilities for the analyst.
By what practical means does he proceed to make his discoveries?
Mainly by hard and systematic work. There are two broad
methods that he may follow. The first consists of a series of
comparative analyses by industrial groups along the lines
described in the previous chapter. Such studies will give him a
fair idea of the standard or usual characteristics of each group
and also point out those companies which deviate widely from
the modal exhibit. If, for example, he discovers that a certain
steel common 6tock has been earning about twice as much on its

684

OTHER ASPECTS OF SECURITY ANALYSIS

685

market price as the industry as a whole, he has a clue to work on—
or rather a suggestion to be pursued by dint of a thoroughgoing
investigation of all the important qualitative and quantitative
factors relating to the enterprise.

The same type of methodical inquiry may be applied to the
field of bonds and preferred stocks. The wide area of receiver¬
ship railroad bonds can best be explored by means of a compara¬
tive analysis of the showing of the bonds of roughly the same rank
issued by, say, a dozen of the major carriers in trusteeship. Or
a large number of public-utility preferred stocks could be listed
according to: (1) their over-all dividend and interest coverage,
(2) their stock-value ratio and (3) their price and yield. Such a
simple grouping might indicate a few issues that either were
well secured and returned more than the average or else were
clearly selling too high in view of their inadequate statistical
protection. And so on.

The second general method consists in scrutinizing corporate
reports as they make their appearance and relating their showing
to the market price of their bonds or stocks. These reports can
be seen—in summary form, at least—in various daily papers;
a more comprehensive presentation can be found in the daily
corporation-report sheets of the financial services or weekly in the
Commercial and Financial Chronicle . A quick glance at a
hundred of such reports may reveal between five and ten that
look interesting enough from the earnings or current-asset
standpoint to warrant more intensive study.

Can Cyclical Swings of Prices Be Exploited?—The best under¬
stood disparities between price and value are those which accom¬
pany the recurrent broad swings of the market through boom
and depression. It is a mere truism that stocks sell too high in a
bull market and too low in a bear market. For at bottom this is
simply equivalent to saying that any upward or downward move¬
ment of prices must finally reach a limit, and since prices do not
remain at such limits (or at any other level) permanently, it
must turn out in retrospect that prices will have advanced or
declined too far.

Can the analyst exploit successfully the repeated exaggera¬
tions of the general market? Experience suggests that a proce¬
dure somewhat like the following should turn out to be reasonably
satisfactory:

686

SECURITY ANALYSIS

1. Select a diversified list of leading common stocks, e.g those in the
“ Dow-Jones Industrial Average.”

2. Determine an indicated “normal” value for this group by applying a
suitable multiplier to average earnings. The multiplier might be equivalent
to capitalizing the earnings at, say, twice the current interest rate on highest
grade industrial bonds. The period for averaging earnings would ordinarily
be seven to ten years, but exceptional conditions such as occurred in 1931-
1933 might suggest a different method, e.g., basing the average on the
period beginning in 1934, when operating in 1939 or later.

3. Make composite purchases of the list when the shares can be bought
at a substantial discount from normal value, say, at % such value. Or
purchases may be made on a scale downwards, beginning say, at 80% of
normal value.

4. Sell out such purchases when a price is reached substantially above
normal value, say, H higher, or from 20 % to 50 % higher on a scale basis.

This was the general scheme of operations developed by Roger
Babson many years ago. It yielded quite satisfactory results
prior to 1925. But—as we pointed out in Chap. XXXVII—
during the 1921-1933 cycle (measuring from low point to low
point) it would have called for purchasing during 1921, selling
out probably in 1926, thus requiring complete abstinence from
the market during the great boom of 1927-1929, and repurchas¬
ing in 1931, to be followed by a severe shrinkage in market
values. A program of this character would have made far too
heavy demands upon human fortitude.

The behavior of the market since 1933 has offered difficulties
of a different sort in applying these mechanical formulas—
particularly in determining normal earnings from which to com¬
pute normal values. It is scarcely to be expected that an idea
as basically simple as this one can be utilized with any high degree
of accuracy in catching the broad market swings. But for those
who realize its inherent limitations it may have considerable
utility, for at least it is likely on the average to result in purchases
at intrinsically attractive levels—which is more than half the
battle in common-stock investment.

“Catching the Swings” on a Marginal Basis Impracticable.—
From the ordinary speculative standpoint, involving purchases
on margin and short sales, this method of operation must be set
down as impracticable. The outright owner can afford to buy
too soon and to sell too soon. In fact he must expect to do
both and to see the market decline farther after he buys and
advance farther after he sells out. But the margin trader is

OTHER ASPECTS OF SECURITY ANALYSIS 687

necessarily concerned with immediate results; he swims with the
tide, hoping to gage the exact moment when the tide will turn
and to reverse his stroke the moment before. In this he rarely
succeeds, so that his typical * experience is temporary success
ending in complete disaster. It is the essential character of the
speculator that he buys because he thinks stocks are going up
not because they are cheap, and conversely when he sells. Hence
there is a fundamental cleavage of viewpoint between the specu¬
lator and the securities analyst, which militates strongly against
any enduringly satisfactory association between them.

Bond prices tend undoubtedly to swing through cycles in
somewhat the same way as stocks, and it is frequently suggested
that bond investors follow the policy of selling their holdings
near the top of these cycles and repurchasing them near the
bottom. We are doubtful if this can be done with satisfactory
results in the typical case. There are no well-defined standards
as to when high-grade bond prices are cheap or dear correspond¬
ing to the earnings-ratio test for common stocks, and the oper¬
ations have to be guided chiefly by a technique of gaging market
moves that seems rather far removed from “investment.” The
loss of interest on funds between the time of sale and repur¬
chase is a strong debit factor, and in our opinion the net advan¬
tage is not sufficient to warrant incurring the psychological
dangers that inhere in any placing of emphasis by the investor
upon market movements.

Opportunities in “Secondary” or Little-known Issues.—

Returning to common stocks, although overvaluation or under¬
valuation of leading issues occurs only at certain points in the
stock-market cycle, the large field of “nonrepresentative” or
“secondary” issues is likely to yield instances of undervaluation
at all times. When the market leaders are cheap, some of the
less prominent common stocks are likely to be a good deal
cheaper. During 1932-1933, for example, stocks such as Plym¬
outh Cordage, Pepperell Manufacturing, American Laundry
Machinery and many others, sold al unbelievably low prices
in relation to their past records and current financial exhibits.
It is probably a matter for individual preference whether the
investor should purchase an outstanding issue like General
Motors at about 50% of its conservative valuation or a less
prominent stock like Pepperell at about 25% of such value.

688

SECURITY ANALYSIS

The Impermanence of Leadership .—The composition of the
market-leader group has varied greatly from year to year, espe¬
cially in view of the recent shift of attention from past perform¬
ance to assumed prospects. If we examine the list during the
decline of 1937-1938, we shall find quite a number of once out¬
standing issues that sold at surprisingly low prices in relation to
their statistical exhibits.

Example: A startling example of this sort is provided by Great
Atlantic and Pacific Tea Company common, which in 1929 sold
as high as 494 and in 1938 as low as 36. Salient data on this
issue are as follows:

Year 1

Sales (000
omitted)

Net (000
omitted)

Earned per
share of

common

Dividend
paid on
common

Price
range of
common

1938

S 878,972

$15,834

$ 6.71

$4.00

72 - 36

1937

881,703

9,119

3.50

6.25

117K- 45^

1936

907,371

17,085

7.31

7.00

130K-110H

1935

872,244

16,593

7.08

7.00

140 -121

1934

842,016

16,709

7.13

7.00

150 -122

1933

819,617

20,478

8.94

7.00

181^-115

1932

863,048

22,733

10.02

7.00

168 -103H

1931

1,008,325

29,793

13.40

6.50

260 -130

1930

1,065,807

30,743

13.86

5.25

260 -155

1929

1,053,693

26,220

11.77

4 50

494 -162

1 Year ended following Jan. 31, except price range.

The balance sheet of January 31, 1938, showed cash assets
of 85 millions and net current assets of 134 millions. At the
1938 low prices, the preferred and common together were selling
for 126 millions. Here, then, was a company whose spectacular
growth was one of the great romances of American business, a
company that was without doubt the largest retail enterprise in
America and perhaps in the world, that had an uninterrupted
record of earnings and dividends for many years—and yet was
selling for less than its net current assets alone. Thus one of the
outstanding businesses of the country was considered by Wall
Street in 1938 to be worth less as a going concern than if it were
liquidated. Why? First, because of chain-store tax threats;
second, because of a recent decline in earnings and, third, because
the general market was depressed.

OTHER ASPECTS OF SECURITY ANALYSIS

689

We doubt that a better illustration can be found of the real
nature of the stock market, which does not aim to evaluate
businesses with any exactitude but rather to express its likes and
dislikes, its hopes and fears, in the form of daily changing quota¬
tions. There is indeed enough sound sense and selective judg¬
ment in the markets activities to create on most occasions some
degree of correspondence between market price and ascertainable
or intrinsic value. In particular, as was pointed out in Chap. IV,
when we are dealing with something as elusive and nonmathe-
matical as the evaluation of future prospects, we are generally
led to accept the market’s verdict as better than anything that
the analyst can arrive at. But, on enough occasions to keep the
analyst busy, the emotions of the stock market carry it in either
direction beyond the limits of sound judgment.

Opportunities in Normal Markets .—During the intermediate
period, when average prices show no definite signs of being either
too low or too high, common stocks may usually be found that
seem definitely undervalued on a statistical basis. These gen¬
erally fall into two classes: (1) Those showing high current and
average earnings in relation to market price and (2) those making

Group A. —Common Stocks Selling at the End of 1938 or 1939 at Less
Than 7 Times Past Year’s Earnings and Also at Less Than Net
Current Asset Value

* These stooks belong also in Group B .
t Partly estimated.

1934-

per

1939 per
share

$1.20

$12.07

$14.38

1.75

11.42

23.95

2.14

12 84

27.83

1 25

13 60 f

20 00t

defO.10

39.67

97.50

0.80

11.04

16.90

1.78

13.44

16.02

1.44

11.66

14.05

690

SECURITY ANALYSIS

Group B .— Common Stocks Selling at the End op 1938 or 1939 at
Two-thirds, or Less, of Net Current Asset Value and Also
at Less Than 12 Times Either Past Year’s or Average Earnings

Company

Year

taken

Price

Dec.

Earnings
for year
per
share

Average
earnings
1934-
1938 or
1934-
1939 per
share

Net

current

asset

value

per

Net

tangible

asset

value

per

Butler Bros.

1939

$0.83

$0.27

$12.75

$19.59

Ely & Walker.

1939

2.30

1.83

48.51

Gilchrist.

1939

0.70*

13 85

17.39

Hale Bros. Stores.. ..

1939

1.81

22.13

28.14

Intertype.

1939

0.55

19.77

22.35

Lee & Cady.

1939

0.77

11.35

12.61

H. D. Lee Mercantile

1938

0.87

1.35

Manhattan Shirt.

1938

11X

0.73

19.36

Reliance Mfg.

1939

1.69

0.94

18.97

22.21

S. Stroock.

1939

1.21

1.39

14.90

26.61

* Years ended following Jan 31.

a reasonably satisfactory exhibit of earnings and selling at a low
price in relation to net-current-asset value. Obviously, such
companies will not be large and well known, or else the trend
of earnings will not have been encouraging. In the appended
table are given a number of companies falling in each group as of
the end of 1938 or 1939, at which times the market level for
industrial stocks did not appear to be especially high or especially
low.

It is not difficult for the assiduous analyst to find interesting
statistical exhibits such as those presented in our table. Much
more difficult is the task of determining whether or not the quali¬
tative factors will justify following the quantitative indications
—in other words, whether or not the investor may have sufficient
confidence in the company’s future to consider its shares a real
bargain at the apparently subnormal price.

On this question the weight of financial opinion appears
inclined to a generally pessimistic conclusion. The investment
trusts, with all their facilities for discovering opportunities of
this type, have paid little attention to them—partly, it is true,
because they are difficult to buy and sell in the large quantities

OTHER ASPECTS OF SECURITY ANALYSIS

691

that the trusts prefer, but also because of their conviction that
however good the statistical exhibit of a secondary company
may be it is not likely to prove a profitable purchase unless there
is specific ground for optimism regarding its future.

The main drawback of a typical smaller sized company is its
vulnerability to a sudden and perhaps permanent loss of its earn¬
ing power. Undoubtedly such adverse developments occur in a
larger proportion of cases in this group than among the larger
enterprises. As an offset to this we h^ve the fact that the suc¬
cessful small company can multiply its value far more impres¬
sively than those which are already of enormous size. For
example, the growth of Philip Morris, Inc., in market value from
5 millions in 1934 to 90 millions in 1939, accompanying a 1,200%
increase in net earnings, would have been quite inconceivable in
the case of American Tobacco. Similarly, the growth of Pepsi¬
Cola has far outstripped in percentage that of Coca-Cola; the
same is true of General Shoe vs. International Shoe; etc.

But most students will try to locate the potential Philip Morris
opportunities, by gaging future possibilities with greater or less
care, and will then buy their shares even at a fairly high price—
rather than make their commitments in a diversified group of
“bargain issues” with only ordinary prospects. Our own
experience leads us to favor the latter technique, although we
cannot guarantee brilliant results therefrom under present-day
conditions. Yet judging from observations made over a number
of years, it would seem that investment in apparently under¬
valued common stocks can be carried on with a very fair degree of
over-all success, provided average alertness and good judgment
are used in passing on the future-prospect question—and pro¬
vided also that commitments are avoided at times when the
general market is statistically much too high. Two older exam¬
ples of this type of opportunity are given here, to afford the reader
some notion of former stock markets.

Florence Stove Common Firestone Tire & Rubber Common

Price in Jan. 1935...

. . 35

Price in Nov. 1925.

120

Dividend.

Earned per share:

Earned pci share year ended Oct.:

1934.

$7.93

1925.

... $32.57*

1933. .

7.98

1924.

16.92

1932.

. 3 33

1923.

14.06

1931.

. 2.27

1922.

... 17.08

• Earnings before contingency reserves were $40.05 per share.

692

SECURITY ANALYSIS

In these cases the market price had failed to reflect adequately
the indicated earning power.

Market Behavior of Standard and Nonstandard Issues. —A

close study of the market action of common stocks suggests the
following further general observations:

1. Standard or leading issues almost always respond rapidly to changes
in their reported profits—so much so that they tend regularly to exaggerate
marketwise the significance of year-to-year fluctuations in earnings.

2. The action of the less familiar issues depends largely upon what attitude
is taken towards them by professional market operators. If interest is
lacking, the price may lag far behind the statistical showing. If interest is
attracted to the issue, either manipulatively or more legitimately, the oppo¬
site result can readily be attained, and the price will respond in extreme
fashion to changes in the company's exhibit.

Examples of Behavior of Nonstandard Issues .—The following
two examples will illustrate this diversity of behavior of non¬
representative common stocks.

Hutte and Superior Copper (Actually Zinc) Company Common

Period

Earnings
per share

Dividend
per share

Price range

Year, 1914.

$ 6.21

1st quarter, 1915.

4.27

2d quarter, 1915.

7.73

3.25

3d quarter, 1915.

10.13

5.75

4th quarter, 1915.

11.34

8.25

Year 1915 ....

$33.47

$18.00

80-36

Year 1916... ...

30.58

34.00

105-42

These were extraordinarily large earnings and dividends.
Even allowing for the fact that they were due to wartime prices
for zinc, the market price showed none the less a striking disregard
of the company’s spectacular exhibit. The reason was lack of
general interest or of individual market sponsorship.

Contrast the foregoing with the appended showing of the
common stock of Mullins Body (later Mullins Manufacturing)
Corporation.

Between 1924 and 1926 we note the characteristic market
swings of a low-priced “ secondary ” common-stock issue. At the

OTHER ASPECTS OF SECURITY ANALYSIS

693

Year

Earned per share

Dividend

Price range

1924

$1.91

None

18-9

1925

2.47

None

22-13

1926

1.97

None

20-8

1927

5.13

None

79-10

1928

6 53

None

95-69

1929

2.67

None

82-10

beginning of 1927 the shares were undoubtedly attractive,
speculatively, at about 10, for the price was low in relation to the
earnings of the three years previously. A substantial, but by
no means spectacular, rise in profits during 1927-1928 resulted
in a typical stock-market exploitation. The price advanced
from 10 in 1927 to 95 in 1928 and fell back again to 10 in 1929.

A contrast of another kind is afforded by the behavior of the
aircraft-manufacturing stocks in 1938-1939, as compared with
that of war beneficiaries in 1915-1918. The two following
examples will illustrate the relationship between market price in
1938 and 1939 and actual performance at the time.

Boeing Airplane Co.

Glenn L. Martin Co.

Date.

December 1938

November 1939

Market value of company

$25,270,000
(722,000 sh. @35)

$49,413,000
(1,092,000sh. @45)4)

Sales 1938.

2,006,000

12,417,000

Net 1938.

555,000(d)

2,349,000

Sales, 9 months 1939 ...

6,566,000

8,506,000

Net, 9 months 1939 .

2,606,000{d)

1,514,000

Tangible assets, Sept. 30, 1939. .

4,527,000

15,200,000

In these cases the market was evidently capitalizing the
as yet unrealized profits from war orders as if they supplied a
permanent basis of future earnings. The contrast between the
Butte and Superior price-earnings ratio in 1915-1916 and that
of these aircraft concerns in 1938-1939 is very striking.

Relationship of the Analyst to Such Situations .—The analyst
can deal intelligently and fairly successfully with situations
such as Wright Aeronautical, Bangor and Aroostook, Firestone
and Butte and Superior at the periods referred to. He could

694

SECURITY ANALYSIS

even have formed a worth-while opinion about Mullins early in
1927. But once this issue fell into market operators* hands it
passed beyond the pale of analytical judgment. As far as Wall
Street was concerned, Mullins had ceased to be a business and
had become a symbol on the ticker tape. To buy it or to sell it
was equally hazardous; the analyst could warn of the hazard,
but he could have no idea of the limits of its rise or fall. (As it
happened, however, the company issued a convertible preferred
stock in 1928 which made possible a profitable hedging operation,
consisting of the purchase of the preferred and the sale of the
common.) Similarly with the airplane issues in 1939, the analyst
could go no further than to indicate the obvious hazard that lay
in treating as permanent a source of business that the whole
world must necessarily hope was essentially temporary.

When the general market appears dangerously high to the
analyst, he must be hesitant about recommending unfamiliar
common stocks, even though they may seem to be of the bargain
type. A severe decline in the general market will affect all
stock prices adversely, and the less active issues may prove
especially vulnerable to the effects of necessitous selling.

Market Exaggerations Due to Factors Other than Changes in
Earnings: Dividend Changes .—The inveterate tendency of the
stock market to exaggerate extends to factors other than changes
in earnings. Overemphasis is laid upon such matters as divi¬
dend changes, stock split-ups, mergers and segregations. An
increase in the cash dividend is a favorable development, but it
is absurd to add $20 to the price of a stock just because the
dividend rate is advanced from $5 to $6 annually. The buyer
at the higher price is paying out in advance all the additional
dividends that he will receive at the new rate over the next 20 years.
The excited responses often made to stock dividends are even
more illogical, since they are in essence nothing more than pieces
of paper. The same is true of split-ups, which create more
shares but give the stockholder nothing he did not have before—
except the minor advantage of a possibly broader market due
to the lower price level. 1

1 In the Atlas Tack manipulation of 1933 an effort was made to attract
public buying by promising a split-up of the stock, 3 shares for 1. Obvi¬
ously, such a move could make no real difference of any kind in the case
of an issue selling in the 30s. The circumstances surrounding the rise of

OTHER ASPECTS OF SECURITY ANALYSIS

695

Mergers and Segregations .—Wall Street becomes easily enthusi¬
astic over mergers and just as ebullient over segregations, which
are the exact opposite. Putting two and two together frequently
produces five in the stock market, and this five may later be
split up into three and three. Such inductive studies as have
been made of the results following mergers seem to cast consider¬
able doubt upon the efficacy of consolidation as an aid to earning
power. 1 There is also reason to believe that the personal clement
in corporate management often stands in the way of really
advantageous consolidations and that those which are consum¬
mated are due sometimes to knowledge by those in control of
unfavorable conditions ahead.

The exaggerated response made by the stock market to
developments that seem relatively unimportant in themselves is
readily explained in terms of the psychology of the speculator.
He wants “action,” first of all; and he is willing to contribute to
this action if he can be given any pretext for bullish excitement.
(Whether through hypocrisy or self-deception, brokerage-house
customers generally refuse to admit they are merely gambling
with ticker quotations and insist upon some ostensible “reason”
for their purchases.) Stock dividends and other “favorable
developments” of this character supply the desired pretexts, and
they have been exploited by the professional market operators,
sometimes with the connivance of the corporate officials. The
whole thing would be childish if it were not so vicious. The
securities analyst should understand how these absurdities of
Wall Street come into being, but he would do well to avoid any
form of contact with them.

Litigation .—The tendency of Wall Street to go to extremes is
illustrated in the opposite direction by its tremendous dislike
of litigation. A lawsuit of any significance casts a damper

Atlas Tack from to 34% in 1933 and its precipitous fall to 10 are worth
studying as a perfect example of the manipulative pattern. It is illuminat¬
ing to compare the price-earnings and the price-assets relationships of the
same stock prior to 1929.

1 See, for example, Arthur S. Dewing, “ A Statistical Test of the Success
of Consolidaturns/* published in Quarterly Journal of Economics , November
1921 and reprinted in his Financial Policy of Corporations , pp. 885-898,
New York, 1926. But see Henry R. Seager and Charles A. Gullick, Trust
and Corporation Problems , pp. 659-661, New York, 1929, and Report of the
Committee on Recent Economic Changes , Vol. I, pp. 194 Jf., New York, 1929

696

SECURITY ANALYSIS

on the securities affected, and the extent of the decline may be
out of all proportion to the merits of the case. Developments
of this kind may offer real opportunities to the analyst, though
of course they are of a specialized nature. The aspect of broadest
importance is that of receivership. Since the undervaluations
resulting therefrom are almost always confined to bond issues,
we shall discuss this subject later in the chapter in connection
with senior securities.

Example: A rather striking example of the effect of litigation
on common-stock values is afforded by the Reading Company
case. In 1913 the United States government brought suit to
compel separation of the company’s railroad and coal properties.
The stock market, having its own ideas of consistency, considered
this move as a dangerous attack on Reading, despite the fact
that the segregation would in itself ordinarily be considered as
“bullish.” A plan was later agreed upon (in 1921) under which
the coal subsidiary’s stock was in effect to be distributed pro rata
among the Reading Company’s common and preferred share¬
holders. This was hailed in turn as a favorable development,
although in fact it constituted a victory for the government
against the company.

Some common stockholders, however, objected to the partici¬
pation of the preferred stock in the coal company “rights.”
Suit was brought to restrict these rights to the common stock.
Amusingly, but not surprisingly, the effect of this move was to
depress the price of Reading common. In logic, the common
should have advanced, since, if the suit were successful, there
would be more value for the junior shares, and, if it failed (as it
did), there would be no less value than before. But the stock
market reasoned merely that here was some new litigation and
hence Reading common should be “let alone.”

Situations involving litigation frequently permit the analyst
to pursue to advantage his quantitative approach in contrast
with the qualitative attitude of security holders in general.
Assume that the assets of a bankrupt concern have been turned
into cash and there is available for distribution to its bondholders
the sum of, say, 50% net. But there is a suit pending, brought
by others, to collect a good part of this money. It may be that
the action is so far-fetched as to be almost absurd; it may be that
it has been defeated in the lower courts, and even on appeal, and

OTHER ASPECTS OF SECURITY ANALYSIS

697

that it has now but a microscopic chance to be heard by the
United States Supreme Court. Nevertheless, the mere pendency
of this litigation will severely reduce the market value of the
bonds. Under the conditions nan^ed, they are likely to sell as
low as 35 instead of 50 cents on the dollar. The anomaly here
is that a remote claim, which the plaintiff can regard as having
scarcely any real value to him, is made the equivalent in the
market to a heavy liability on the part of the defendant. We
thus have a mathematically demonstrable case of undervalua¬
tions, and, taking these as a class, they lend themselves exceed¬
ingly well to exploitation by the securities analyst.

Examples: Island Oil and Transport 8% Notes .—In June 1933
these notes were selling at 18. The receiver held a cash fund
equivalent to about 45% on the issue, from which were deductible
certain fees and allowances, indicating a net distributable balance
of about 30 for the notes. The distribution was being delayed
by a suit for damages that had been repeatedly unsuccessful
in its various legal stages and was now approaching final deter¬
mination. This suit was exerting an adverse effect upon the
market value of the notes out of all proportion to its merits, a
statement that is demonstrable from the fact that the litigation
could have been settled by payment of a relatively small amount.
After the earlier decisions were finally sustained by the higher
courts, the noteholders received a distribution of $290 per $1,000
in April 1934. A small additional distribution was indicated. 1

A similar situation arose in the case of United Shipyards
Corporation stock after ratification of the sale of its properties
to Bethlehem Steel Company in 1938. Dissenting holders
brought suit to set the sale aside on the ground that the price was
grossly inadequate. The effect of this litigation was to hold
down the price of the Class B common to 1^4 in January 1939,
as against a realizable value of between 2% to 3 if the sale was

1 A very similar situation existed in 1938 in connection with the various
bond issues of National Bondholders Corporation, which was engaged in
liquidating various properties and claims. These securities were selling at
considerably less than the amount realizable for them in liquidation, chiefly
because of certain suits involving a substantial cash fund. As in the Island
Oil example, this litigation was in the last stages of appeal, and the decisions
theretofore had all been favorable to the bondholders. Following the final
decision the value of a typical issue advanced from 26 bid in 1938 to the
equivalent of 41 bid in 1939.

698

SECURITY ANALYSIS

upheld. Obviously, if the suit had any merit, the stock should
have been worth more rather than less than 2^; alternatively,
if it had no merit, as seemed clear, then the shares were clearly
worth twice their selling price. (A similar disparity existed in
connection with the price of the Class A stock.)

Undervalued Investment Issues. —Undervalued bonds and
preferred stocks of investment caliber may be discovered in any
period by means of assiduous search. In many cases the low
price of a bond or preferred stock is due to a poor market, which
in turn results from the small size of the issue, but this very
small size may make for greater inherent security. The Electric
Refrigeration Building Corporation 6s, due 1936, described in
Chap. XXVI, are a good example of this paradox.

At times some specific development greatly strengthens the
position of a senior issue, but the price is slow to reflect this
improvement, and thus a bargain situation is created. These
developments relate usually to the capitalization structure or to
corporate relationships. Several examples will illustrate our
point.

Examples: In 1923 Youngstown Sheet and Tube Company
purchased the properties of Steel and Tube Company of America
and assumed liability for the latter's General Mortgage 7s, due
1951. Youngstown sold a 6% debenture issue at 99 to supply
funds for this purchase. The following price relationship
obtained at the time:

Company

Price

Yield, %

Youngstown Sheet and Tube Debenture 6s.

6.02

Steel and Tube General 7s.

102

6.85

The market failed to realize the altered status of the Steel and
Tube bonds, and thus they sold illogically at a higher yield than
the unsecured issue of the same obligor company. This pre¬
sented a clear-cut opportunity to the analyst to recommend a
purchase or an exchange.

In 1922 the City of Detroit purchased the urban lines of
Detroit United Railway Company and agreed to pay therefor
sums sufficient to retire the Detroit United Railway First 43^s,
due 1932. Unusually strong protective provisions were inserted

OTHER ASPECTS OF SECURITY ANALYSIS

699

in the purchase contract which practically, if not technically,
made the City of Detroit liable for the bonds. But, after the
deal was consummated, the bonds sold at 82, yielding more than
7 %. The bond market failed to -recognize their true status as
virtual obligations of the City of Detroit.

In 1924 Congoleum Company had outstanding $1,800,000
of 7% preferred stock junior to $2,890,000 of bonds and followed
by 960,000 shares of common stock having an average market
value of some $48,000,000. In October of that year the company
issued 681,000 additional shares of common for the business of
the Nairn Linoleum Company, a large unit in the same field,
with $15,000,000 of tangible assets. The enormous equity thus
created for the small senior issues made them safe beyond
question, but the price of the preferred stock remainded under
par.

In 1927 Electric Refrigeration Corporation (now Kelvinator
Corporation) sold 373,000 shares of common stock for $6,600,000,
making a total of 1,000,000 shares of common stock, with average
market value of about $21,000,000, coming behind only $2,880,-
000 of 6% notes, due in 1936. The notes sold at 74, however,
to yield 11 %. The low price was due to a large operating deficit
incurred in 1927, but the market failed to take into account the
fact that the receipt of a much greater amount of new cash from
the sale of additional stock had established a very strong backing
for the small note issue.

These four senior issues have all been paid off at par or higher.
(The Congoleum-Nairn Preferred was called for payment at 107
in 1934.) Examples of this kind are convenient for the authors
since they do not involve the risk of some later mischance casting
doubt upon their judgment. To avoid loading the dice too
heavily in our favor, we add another illustration which is current
as this chapter is written.

A Current Example .—Choctaw and Memphis Railroad Com¬
pany First 5s, due 1949, were selling in 1939 at about 35, carrying
more than 5 years’ unpaid interest. They were a first lien on
underlying mileage of the Chicago, Rock Island and Pacific
System. The Rock Island had been reporting poor earnings since
1930, and all its obligations were in default. However, a segrega¬
tion of the 1937 earnings by mortgage divisions showed that the
Choctaw and Memphis mileage was very profitable and that

700

SECURITY ANALYSIS

its interest charges had been covered 2.0 times in that year
even though the company had earned only $2,700,000 toward
total interest of $14,080,000. Furthermore, the several reor¬
ganization plans presented up to 1939, including that of the
I.C.C. examiner, had all provided for principal and back interest
on this issue in full, although virtually the entire remaining bond
structure was to be drastically cut down, and total interest
charges were to be reduced to less than $2,500,000 annually.

Assuming, as seemed inevitable, that the company was to be
reorganized along the lines proposed, it was clear that these
Choctaw and Memphis bonds would enjoy a very strong position,
whether they were to be left undisturbed with their lien on a
valuable mileage and their back interest paid off, or were to be
given par for par in a new, small first mortgage on the entire
system. This conclusion would be inescapable unless it were
true that a railroad with minimum gross earnings of 65 millions
could not be counted on to meet charges of 2% millions annually
—less than one-fifth its former burden.

Thus all the quantitative factors would seem to indicate
strongly that the Choctaw and Memphis 5s were greatly under¬
valued at 35 and that once the recapitalization was completed the
entrenched position of this issue should become manifest. 1

Price-value Discrepancies in Receiverships.—In Chap. XVIII,
dealing with reorganization procedure, we gave two diverse
examples of disparities arising under a receivership: the Fisk
Rubber case, in which the obligations sold at a ridiculously low
price compared with the current assets available for them; and
the Studebaker case, in which the price of the 6% notes was
clearly out of line with that of the stock. A general statement
may fairly be made that in cases where substantial values are
ultimately realized out of a receivership, the senior securities
will be found to have sold at much too low a price. This char¬
acteristic has a twofold consequence. It has previously led us to

1 See Appendix Note 67, p. 819, for text of the material in the 1934 edition
relating to the Fox Film 6 % Notes, due 1936, which in 1933 were selling at
75 to yield 20% to maturity.

Further Example: In 1938 Tung Sol Lamp Company 4 % Notes, due 1941,
were selling at 50. The very small size of this issue, in relation to the com¬
pany’s resources and earnings, made payment apparently certain. (In
fact they were called in 1939 in advance of maturity.)

OTHER ASPECTS OF SECURITY ANALYSIS

701

advise strongly against buying at investment levels any securities
of a company that is likely to fall into financial difficulties;
it now leads us to suggest that after these difficulties have arisen
they may produce attractive analytical opportunities.

This will be true not only of issues so strongly entrenched as
to come through reorganization unscathed (e g., Brooklyn Union
Elevated 5s, as described in Chap. II) but also of senior securities
which are “scaled down” or otherwise affected in a readjustment
plan. It seems to hold most consistently in cases where liquida¬
tion or a sale to outside interests results ultimately in a cash
distribution or its equivalent.

Examples: Three typical examples of such a consummation
are given herewith.

1. Ontario Power Service Corporation First 5%s, Due 1950.—
This issue defaulted interest payment on July 1, 1932. About
this time the bonds sold as low as 21. The Hydro-Electric
Commission of Ontario purchased the property soon afterwards,
on a basis that gave $900 of new debentures, fully guaranteed
by the Province of Ontario, for each $1,000 Ontario Power
Service bond. The new debentures were quoted at 90 in Decem¬
ber 1933, equivalent to 81 for the old bonds. The small number
of bondholders not making the exchange received 70% in cash.

2. Amalgamated Laundries , Inc., 6 %s, Due 1936.—Receivers
were appointed in February 1932. The bonds were quoted at
4 in April 1932. In June 1932 the properties were sold to outside
interests, and liquidating dividends of 12^% and 2% were paid
in August 1932 and March 1933. In December 1933 the bonds
were still quoted at 4, indicating expectation of at least that
amount in further distributions.

3. Fisk Rubber Company First 8 s and Debenture 5 %s, Due 1941
and 1931.—Information regarding these issues was given in
Chap. XVIII. Receivership was announced in January 1931.
In 1932 the 8s and 5j^s sold as low as 16 and 103^ respectively.
In 1933 a reorganization was effected, which distributed 40% in
cash on the 8s and 37 % on the 53^s, together with securities of
two successor companies. The aggregate values of the cash and
the new securities at the close of 1933 came close to 100% for
the 8% bonds and 70% for the debenture 53^s.

Price Patterns Produced by Insolvency.—Certain price pat¬
terns are likely to be followed during receivership or bankruptcy

702

SECURITY ANALYSIS

proceedings, especially if they are protracted. In the first place,
there is often a tendency for the stock issues to sell too high, not
only in relation to the price of the bond issues but also absolutely,
i.e., in relation to their probable ultimate value. This is due to
the incidence of speculative interest, which is attracted by a
seemingly low price range. In the case of senior issues, popular
interest steadily decreases, and the price tends to decline accord¬
ingly, as the proceedings wear on. Consequently, the lowest
levels are likely to be reached a short time before a reorganization
plan is ready to be announced.

A profitable field of analytical activity should be found there¬
fore in keeping in close touch with such situations, endeavoring
to discover securities that appear to be selling far under their
intrinsic value and to determine approximately the best time for
making a commitment in them. But in these, as in all analytical
situations, we must warn against an endeavor to gage too nicely
the proper time to buy. An essential characteristic of security
analysis, as we understand it, is that the time factor is a subordi¬
nate consideration. Hence our use of the qualifying word
“approximately,” which is intended to allow a leeway of several
months and sometimes even longer, in judging the “ right time”
to enter upon the operation.

Opportunities in Railroad Trusteeships.—In the years follow¬
ing 1932 a large part of the country’s railroad mileage went into
the hands of trustees. At the close of 1938 a total of 111 railway
companies operating 78,016 miles (31% of the total railway
mileage in the United States) were in the hands of receivers or
trustees. This is the greatest mileage ever in the hands of the
courts at any one time. Reorganization in every case has been
long delayed, owing on the one hand to the complicated capital
structures to be dealt with and on the other to the uncertainty as
to future normal earnings. As a result the price of a great many
issues fell to extremely low levels—which would undoubtedly
have presented excellent opportunities for the shrewd investor,
had it not been that the earnings of the railroads as a whole
continued for some years to make disappointing showings as
compared with general business.

Viewing the situation about the end of 1939, it appeared
that many of the first-mortgage liens on important mileage had
fallen to lower levels than were warranted by anything but a most

OTHER ASPECTS OF SECURITY ANALYSIS

703

pessimistic view of the future of the carriers. Certainly, these
issues were cheaper than the bonds and stocks of solvent roads,
which sold for the most part at liberal prices in relation to their
current exhibits and which in many cases would be in danger of
insolvency if future conditions turned out as badly as the low
price of trusteeships issues seemed to anticipate. The technique
of analyzing issues of the latter group is covered in Chap. XII
and in Appendix Note 66, page 807.

CHAPTER LI

DISCREPANCIES BETWEEN PRICE AND VALUE

(' Continued)

The practical distinctions drawn in our last chapter between
leading and secondary common stocks have their counterpart in
the field of senior securities as between seasoned and unseasoned
issues. A seasoned issue may be defined as an issue of a company
long and favorably known to the investment public. (The
security itself may be of recent creation so long as the company
has a high reputation among investors.) Seasoned and unsea¬
soned issues tend at times to follow divergent patterns of conduct
in the market, viz.:

1. The price of seasoned issues is often maintained despite a considerable
weakening of their investment position.

2. Unseasoned issues are very sensitive to adverse developments of any
nature. Hence they often fall to prices far lower than seem to be warranted
by their statistical exhibit.

Price Inertia of Seasoned Issues.—These opposite character¬
istics are due, in part at least, to the inertia and lack of penetra¬
tion of the typical investor. He buys by reputation rather than
by analysis and he holds tenaciously to what he has bought.
Hence holders of long-established issues do not sell them readily,
and even a small decline in price attracts buyers long familiar
with the security.

Example: This trait of seasoned issues is well illustrated by
the market history of the United States Rubber Company 8%
Noncumulative Preferred. The issue received full dividends
between 1905 and 1927. In each year of this period except 1924
there were investors who paid higher than par for this stock. Its
popularity was based entirely upon its reputation and its dividend
record, for the statistical exhibit of the company during most of
the period was anything but impressive, even for an industrial
bond, and hence ridiculously inadequate to justify the purchase of
a noncumulative industrial preferred stock. Between the years
1922 and 1927, the following coverage was shown for interest
charges and preferred dividends combined:

704

OTHER ASPECTS OF SECURITY ANALYSIS

705

1922 . 1.20 times

1923 . 1.18 times

1924 . 1.32 times

1925 . 1.79 times

1926 .». 1.00 times

1927 . l.Oltimes

In 1928 the stock sold as high as 109. During that year the
company sustained an enormous loss, and the preferred dividend
was discontinued. Despite the miserable showing and the
absence of any dividend, the issue actually sold at 92^ in 1929.

(In 1932 it sold at 33^.) 1

Vulnerability of Unseasoned Issues.—Turning to unseasoned
issues, we may point out that these belong almost entirely to the
industrial field. The element of seasoning plays a very small
part as between the various senior issues of the railroads; and in
the public-utility group proper (t.e., electric, manufactured gas,
telephone and water companies) price variations will be found
to follow the statistical showing fairly closely, without being
strongly influenced by the factor of popularity or familiarity—
except in the case of very small concerns.

Industrial financing has brought into the market a continuous
stream of bond and preferred stock issues of companies new to the
investment list. Investors have been persuaded to buy these
offerings largely through the appeal of a yield moderately higher
than the standard rate for seasoned securities of comparable
grade. If the earning power is maintained uninterruptedly
after issuance, the new security naturally proves a satisfactory
commitment. But any adverse development will ordinarily
induce a severe decline in the market price. This vulnerability
of unseasoned issues gives rise to the practical conclusion that it is
unwise to buy a new industrial bond or preferred stock for straight
investment.

Since such issues are unduly sensitive to unfavorable develop¬
ments, it would seem that the price would often fall too low and
in that case they would afford attractive opportunities to pur¬
chase. This is undoubtedly true, but there is great need of cau¬
tion in endeavoring to take advantage of these disparities. In

1 A more recent example of the same kind is presented by Curtis Publish¬
ing 7% Preferred, which sold at 114 in 1936 and 109J6 in 1937, despite an
exceedingly inadequate showing of earnings (and tangible assets). The
high price of many railroad bonds in those years, notwithstanding their
unsatisfactory earnings exhibit, illustrates this point more broadly.

708

SECURITY ANALYSIS

the first place, the disfavor accorded to unseasoned securities
in the market is not merely a subjective matter, due to lack of
knowledge. Seasoning is usually defined as an objective quality,
arising from a demonstrated ability to weather business storms.
Although this definition is not entirely accurate, there is enough
truth in it to justify in good part the investor’s preference for
seasoned issues.

More important, perhaps, is the broad distinction of size and
prominence that can be drawn between seasoned and unseasoned
securities. The larger companies are generally the older com¬
panies, having senior issues long familiar to the public. Hence
unseasoned bonds and preferred stocks are for the most part
issues of concerns of secondary importance. But we have
pointed out, in our discussion of industrial investments (Chap.
VII), that in this field dominant size may reasonably be con¬
sidered a most desirable trait. It follows, therefore, that in this
respect unseasoned issues must suffer as a class from a not incon¬
siderable disadvantage.

Unseasoned Industrial Issues Rarely Deserve an Investment
Rating .—The logical and practical result is that unseasoned
industrial issues can very rarely deserve an investment rating,
and consequently they should only be bought on an admittedly
speculative basis. This requires in turn that the market price
be low enough to permit of a substantial rise; e.g ., the price must
ordinarily be below 70.

It will be recalled that in our treatment of speculative senior
issues (Chap. XXVI), we referred to the price sector of about
70 to 100 as the “range of subjective variation,” in which an
issue might properly sell because of a legitimate difference of
opinion as to whether or not it was sound. It seems, however,
that in the case of unseasoned industrial bonds or preferred
stocks the analyst should not be attracted by a price level within
this range, even though the quantitative showing be quite satis¬
factory. He should favor such issues only when they can be
bought at a frankly speculative price.

Exception may be made to this rule when the statistical
exhibit is extraordinarily strong, as perhaps in the case of the
Fox Film 6% notes mentioned in the preceding chapter and
described in Appendix Note 67, page 819. We doubt if such
exceptions can prudently include any unseasoned industrial
preferred stocks, because of the contractual weakness of such

OTHER ASPECTS OF SECURITY ANALYSIS

707

issues. (In the case of Congoleum preferred, described above,
the company was of dominant size in its field, and the preferred
stock was not so much “unseasoned” as it was inactive
marketwise.)

Discrepancies in Comparative Prices. —Comparisons may or
may not be odious, but they hold a somewhat deceptive fascina¬
tion for the analyst. It seems a much simpler process to decide
that issue A is preferable to issue B than to determine that
issue A is an attractive purchase in its own right. But in our
chapter on comparative analysis we have alluded to the particular
responsibility that attaches to the recommendation of security
exchanges, and we have warned against an overready acceptance
of a purely quantitative superiority. The future is often no
respecter of statistical data. We may frame this caveat in
another way by suggesting that the analyst should not urge a
security exchange unless either (1) the issue to be bought is
attractive, regarded by itself, or (2) there is a definite contractual
relationship between the two issues in question. Let us illustrate
consideration (1) by two examples of comparisons taken from
our records.

Examples: I. Comparison Made in March 1932.

Item

Ward Baking
First 6s, due
1937. Price
85 K, yield
9.70%

Bethlehem Steel First
& Ref. 5s, due 1942.
Price 93, yield 5.90%

Total interest charges earned:

1931 .

8.1 times

1.0 times

1930 .

8.2 times

4.3 times

1929.

11.0 times

4.8 times

1928.

11.2 times

2.7 times

1927.

14.0 times

2.3 times

1926.

14.5 times

2.6 times

1925.

12.6 times

2.1 times

Seven-year average.

11.4 times

2.8 times

Amount of bond issues.

$ 4,546,000

12,200,000

3,438,000

3,494,000

$145,000,000*

116,000,000

50,300,000

116,300,000

Market value of stock issues (March
*32 average).

Cash assets.

Net working capital.

* Including guaranteed stock.

708

SECURITY ANALYSIS

In this comparison the Ward Baking issue made a far stronger
statistical showing than the Bethlehem Steel bonds. Further¬
more, it appeared sufficiently well protected to justify an invest¬
ment rating, despite the high return. The qualitative factors,
although not impressive, did not suggest any danger of collapse of
the business. Hence the bonds could be recommended either
as an original purchase or as an advantageous substitute for the
Bethlehem Steel 5s.

II. Comparison Made in March 1929.

Item

Spear <fe Co.
(Furniture Stores)
7% First Preferred.
Price 77,
yielding 9.09 %

Republic Iron
& Steel 7 %
Preferred,
Price 112,
yielding 6.25%

(Interest and) preferred dividends
earned:

1928.

2.4 times

1.9 times

1927.

4.0 times

1.5 times

1926.

3.0 times

2.1 times

1925.

2.5 times

1.7 times

1924.

4.7 times

1.1 times

1923.

6.5 times

2.5 times

1922.

4.3 times

0.5 times

Seven-year average.

3.9 times

1.6 times
$32,700,000
25,000,000
62,000,000
21,500,000

Amount of bond issues.

None

Amount of (1st) preferred issue.

S 3,900,000
3,200,000*
10,460,000

Market value of junior issues.

Net working capital.

* Includes Second Preferred estimated at 50.

In this comparison the Spear and Company issue undoubtedly
made a better statistical showing than Republic Iron and Steel
Preferred. Taken by itself, however, its exhibit was not suf¬
ficiently impressive to carry conviction of investment merit,
considering the type of business and the fact that we were dealing
with a preferred stock. The price of the issue was not low enough
to warrant recommendation on a fully speculative basis, i.e.,
with prime emphasis on the opportunity for enhancement of
principal. This meant in turn that it could not consistently

OTHER ASPECTS OF SECURITY ANALYSIS

709

be recommended in exchange for another issue, such as Republic
Iron and Steel Preferred.

Comparison of Definitely Related Issues. —When the issues
examined are definitely related,-a different situation obtains.
An exchange can then be considered solely from the standpoint
of the respective merits within the given situation; the responsi¬
bility for entering into or remaining in the situation need not
be assumed by the analyst. In our previous chapters we have
considered a number of cases in which relative prices were clearly
out of line, permitting authoritative recommendations of
exchange. These disparities arise from the frequent failure of
the general market to recognize the effect of contractual provi¬
sions and often also from a tendency for speculative markets to
concentrate attention on the common stocks and to neglect the
senior securities. Examples of the first type were given in our
discussion of price discrepancies involving guaranteed issues in
Chap. XVII. The price discrepancies between various Inter-
borough Rapid Transit Company issues, discussed in the Appen¬
dix, Note 56, and between Brooklyn Union Elevated Railroad 5s
and Brooklyn-Manhattan Transit Corporation 6s, referred to in
Chap. II, are other illustrations in this category. 1

The illogical price relationships between a senior convertible
issue and the common stock, discussed in Chap. XXV, are
examples of opportunities arising from the concentration of specu¬
lative interest on the more active junior shares. A different mani¬
festation of the same general tendency is shown by the spread of
7 points existing in August 1933 between the price of American
Water Works and Electric Company “free” common and the less
active voting trust certificates for the same issue. Such phenom¬
ena invite not only direct exchanges but also hedging operations.

A similar comparison could be made in July 1933 between
Southern Railway 5% Noncumulative Preferred, paying no
dividend and selling at 49, and the Mobile and Ohio Stock Trust

1 The student is invited to consider the price relationships between Pierce
Petroleum and Pierce Oil preferred and common in 1929; between Central
States Electric Corporation 5H% bonds and North American Company
common in 1934; between the common issues of Advance-Rumely Corpora¬
tion and Allis-Chalmers Manufacturing Company in 1933; between Ven¬
tures, Ltd., and Falconbridge Nickel, and between Chesapeake Corporation
and Chesapeake and Ohio Railway common stocks in 1939—as examples of
disparities arising from ownership by one company of securities in another.

710

SECURITY ANALYSIS

Certificates, which were an obligation of the same road, bearing
a perpetual guaranty of a 4% dividend and selling concurrently
at 39%. Even if the preferred dividend had been immediately
resumed and continued without interruption, the yield thereon
would have been no higher than that obtainable from the senior
fixed-interest obligation. (In 1939 Southern Railway Preferred,
still paying no dividend, sold at 35 against a price of about 40 for
the Mobile and Ohio 4% certificates. At these prices the advan¬
tage still appeared clearly on the side of the guaranteed issue.)

Other and Less Certain Discrepancies .—In the foregoing exam¬
ples the aberrations are mathematically demonstrable. There is
a larger class of disparities between senior and junior securities
that may not be proved quite so conclusively but are sufficiently
certain for practical purposes. As an example of these, consider
Colorado Industrial Company 5s, due August 1, 1934, guar¬
anteed by Colorado Fuel and Iron Company, which in May 1933
sold at 43, while the Colorado Fuel and Iron 8% Preferred, paying
no dividend, sold at 45. The bond issue had to be paid off in
full within 14 months’ time, or else the preferred stock was
faced with the possibility of complete extinction through receiver¬
ship. In order that the preferred stock might prove more
valuable than the bonds bought at the same price, it would be
necessary not only that the bonds be paid off at par in little over
a year but that preferred dividends be resumed and back divi¬
dends discharged within that short time. This was almost, if
not quite, inconceivable.

In comparing nonconvertible preferred stocks with common
stocks of the same company, we find the same tendency for the
latter to sell too high, relatively, when both issues are on a
speculative basis. Comparisons of this kind can be safely drawn,
however, only when the preferred stock bears cumulative
dividends. (The reason for this restriction should be clear from
our detailed discussion of the disabilities of noncumulative issues
in Chap. XV.) A price of 10 for American and Foreign Power
Company common when the $7 Cumulative Second Preferred
was selling at 11 in April 1933 was clearly unwarranted. A
similar remark may be made of the price of 21^ for Chicago
Great Western Railroad Company common in February 1927,
against 32J^ for the 4% preferred stock on which dividends of
$44 per share had accumulated.

OTHER ASPECTS OF SECURITY ANALYSIS

711

It is true that if extraordinary prosperity should develop in
situations of this kind, the common shares might eventually be
worth substantially more than the preferred. But even if this
should occur, the company is bound to pass through an inter¬
mediate period during which the improved situation permits it
to resume preferred dividends and then to discharge the accu¬
mulations. Since such developments benefit the preferred stock
directly, they are likely to establish (for a while at least) a market
value for the senior issues far higher than that of the common
stock. Hence, assuming any appreciable degree of improvement,
a purchase of the preferred shares at the low levels should fare
better than one made in the common stock.

Discrepancies Due to Special Supply and Demand Factors.—
The illogical relationships that we have been considering grow
out of supply and demand conditions that are, in turn, the
product of unthinking speculative purchases. Sometimes dis¬
crepancies are occasioned by special and temporary causes
affecting either demand or supply.

Examples: In the illogical relationship between the prices of
Interboro Rapid Transit Company 5s and 7s in 1933, the opera¬
tions of a substantial sinking fund, which purchased the 5s and
not the 7s, were undoubtedly instrumental in raising the price of
the former disproportionately. An outstanding example of
this kind is found in the market action of United States Liberty
4^£s during the postwar readjustment of 1921-1922. Large
amounts of these bonds had been bought during the war for
patriotic reasons and financed by bank loans. A general desire
to liquidate these loans later on induced a heavy volume of sales
which drove the price down. This special selling pressure
actually resulted in establishing a lower price basis for Liberty
Bonds than for high-grade railroad issues, which were, of course,
inferior in security and at a greater disadvantage also in the
matter of taxation. Compare the following simultaneous prices
in September 1920.

Issue

Price

Yield

United States Liberty Fourth 4J^s, due 1938.

Union Pacific First 4s, due 1947.

84H

5.64%*

5.42%

* Not allowing for tax exemption.

712

SECURITY ANALYSIS

This situation supplied an excellent opportunity for the
securities analyst to advise exchanges from the old-line railroad
issues into Liberty Bonds.

A less striking disparity appeared a little later between the
price of these Liberty Bonds and of United States Victory 4%s,
due 1923. This state of affairs is discussed in a circular, prepared
by one of the authors and issued at that time, a copy of which is
given in the Appendix, Note 68, as an additional example of
“practical security analysis.”

United States Savings Bonds Offer Similar Opportunity. —For

the investor of moderate means the disparity between United
States government and corporate obligations has reappeared in
recent years. The yield on United States Savings Bonds (avail¬
able to any one individual to the extent of $10,000 principal
amount each year) is 2.90% on the regular compound-interest
basis of calculation and 3.33 % on a simple-interest basis. This
yield is definitely higher than that returned by best rated public
utility and industrial issues. 1 In addition to their safety factor,
which at present must clearly be set higher than that of any
corporate issue, the United States Savings Bonds have the minor
advantage of exemption from normal income tax and the major
advantage of being redeemable at the option of the holder at any
time, thus guaranteeing him against intermediate loss in market
value.

1 The average yields for such bonds for the first 3 months of 1940, carry¬
ing A1+ ratings of Standard Statistics Company, were only 2.62% and
2.44%, respectively.

CHAPTER LII

MARKET ANALYSIS AND SECURITY ANALYSIS

Forecasting security prices is not properly a part of security
analysis. However, the two activities are generally thought
to be closely allied, and they are frequently carried on by the
same individuals and organizations. Endeavors to predict the
course of prices have a variety of objectives and a still greater
variety of techniques. Most emphasis is laid in Wall Street
upon the science, or art, or pastime, of prophesying the immediate
action of the “general market,” which is fairly represented by the
various averages used in the financial press. Some of the
services or experts confine their aim to predicting the longer term
trend of the market, purporting to ignore day-to-day fluctuations
and to consider the broader “swings” covering a period of, say,
several months. A great deal of attention is given also to
prophesying the market action of individual issues, as distinct
from the market as a whole.

Market Analysis as a Substitute for or Adjunct to Security
Analysis.—Assuming that these activities are carried on with
sufficient seriousness to represent more than mere guesses, we
may refer to all or any of them by the designation of “market
analysis.” In this chapter we wish to consider the extent to
which market analysis may seriously be considered as a substitute
for or a supplement to security analysis. The question is
important. If, as many believe, one can dependably foretell
the movements of stock prices without any reference to the
underlying values, then it would be sensible to confine security
analysis to the selection of fixed-value investments only. For,
when it comes to the common-stock type of issue, it would
manifestly be more profitable to master the technique of deter¬
mining when to buy or sell, or of selecting the issues that are
going to have the greatest or quickest advance, than to devote
painstaking efforts to forming conclusions about intrinsic value.
Many other people believe that the best results can be obtained

713

714

SECURITY ANALYSIS

by an analysis of the market position of a stock in conjunction
with an analysis of its intrinsic value. If this is so, the securities
analyst who ventures outside the fixed-value field must qualify
as a market analyst as well and be prepared to view each situa¬
tion from both standpoints at the same time.

It is not within our province to attempt a detailed criticism
of the theories and the technique underlying all the different
methods of market analysis. We shall confine ourselves to
considering the broader lines of reasoning that are involved
in the major premises of price forecasting. Even with this
sketchy treatment it should be possible to reach some useful
conclusions on the perplexing question of the relationship
between market analysis and security analysis.

Two Kinds of Market Analysis.—A distinction may be made
between two kinds of market analysis. The first finds the
material for its predictions exclusively in the past action of the
stock market. The second considers all sorts of economic factors,
e.g.y business conditions, general and specific; money rates; the
political outlook. (The market’s behavior is itself only one of
these numerous elements of study.) The underlying theory of
the first approach may be summed up in the declaration that
“the market is its own best forecaster.” The behavior of the
market is generally studied by means of charts on which are
plotted the movements of individual stocks or of “averages.”
Those who devote themselves primarily to a study of these
price movements are known as “chartists,” and their procedure
is often called “chart reading.”

But it must be pointed out that much present-day market
analysis represents a combination of the two kinds described,
in the sense that the market’s action alone constitutes the pre¬
dominant but not the exclusive field of study. General economic
indications play a subordinate but still significant role. Con¬
siderable latitude is therefore left for individual judgment, not
only in interpreting the technical indications of the market’s
action but also in reconciling such indications with outside
factors. The “Dow theory,” however, which is the best known
method of market analysis, limits itself essentially to a study of
the market’s behavior. Hence we feel justified in dealing
separately with chart reading as applied exclusively to stock
prices.

OTHER ASPECTS OF SECURITY ANALYSIS . 715

Implication of the First Type of Market Analysis . —It must be
recognized that the vogue of such 11 technical study'' has increased
immensely during the past fifteen years. Whereas security
analysis suffered a distinct loss of prestige beginning about 1927—
from which it has not entirely recovered—chart reading appar¬
ently increased the number of its followers even during the long
depression and in the years thereafter. Many sceptics, it is
true, are inclined to dismiss the whole procedure as akin to
astrology or necromancy, but the sheer weight of its importance
in Wall Street requires that its pretensions be examined with
some degree of care. In order to confine our discussion within
the framework of logical reasoning, w*e shall purposely omit
even a condensed summary of the main tenets of chart reading. 1
We wish to consider only the implications of the general idea that
a study confined to past price movements can be availed of
profitably to foretell the movements of the future.

Such consideration, we believe, should lead to the following
conclusions:

1. Chart reading cannot possibly be a science.

2. It has not proved itself in the past to be a dependable method of making
profits in the stock market.

3. Its theoretical basis rests upon faulty logic or else upon mere assertion.

4. Its vogue is due to certain advantages it possesses over haphazard
speculation, but these advantages tend to diminish as the number of chart
students increases.

1. Chart Reading Not a Science and Its Practice Cannot Be Con¬
tinuously Successful .—That chart reading cannot be a science
is clearly demonstrable. If it were a science, its conclusions
would be as a rule dependable. In that case everybody could
predict tomorrow's or next week's price changes, and hence
everyone could make money continuously by buying and selling
at the right time. This is patently impossible. A moment's
thought wdll show that there can be no such thing as a scientific

1 For detailed statements concerning the theory and practice of chart
reading the student is referred to: R. W. Shabacker, Stock Market Profits ,
B. C. Forbes, New York, 1934; Robert Rhea, “The Dow Theory,” passim ,
Barron's , New York, 1932; H. M. Gartley, “Analyzing the Stock Market,”
a series of articles in Barron's beginning with the issue of Sept. 19, 1932
and ending with the issue of Dec. 5, 1932. See Appendix Note 69, p. 821,
for a brief statement of the main tenets of the Dow theory.

716

SECURITY ANALYSIS

prediction of economic events under human control. The very
‘* dependability” of such a prediction will cause human actions
that will invalidate it. Hence thoughtful chartists admit that
continued success is dependent upon keeping the successful
method known to only a few people.

2. Because of this fact it follows that there is no generally
known method of chart reading that has been continuously
successful for a long period of time. 1 If it were known, it would
be speedily adopted by numberless traders. This very following
would bring its usefulness to an end.

3. Theoretical Basis Open to Question .—The theoretical basis
of chart reading runs somewhat as follows:

a. The action of the market (or of a particular stock) reflects the activities
and the attitude of those interested in it.

b. Therefore, by studying the record of market action, we can tell what
is going to happen next in the market.

The premise may well be true, but the conclusion docs not
necessarily follow. You may learn a great deal about the
technical position of a stock by studying its chart, and yet you
may not learn enough to permit you to operate profitably in the
issue. A good analogy is provided by the “past performances’*
of race horses, which are so assiduously studied by the devotees
of the race track. Undoubtedly these charts afford consider¬
able information concerning the relative merits of the entries;
they will often enable the student to pick the winner of a race;
but the trouble is that they do not furnish that valuable informa¬
tion often enough to make betting on horse races a profitable
diversion.

Coming nearer home, we have a similar situation in security
analysis itself. The past earnings of a company supply a useful
indication of its future earnings—useful, but not infallible.
Security analysis and market analysis are alike, therefore, in the
fact that they deal with data that are not conclusive as to the
future. The difference, as we shall point out, is that the securi¬
ties analyst can protect himself by a margin of safety that is
denied to the market analyst.

1 Adherents of the Dow theory claim that it has been continuously success¬
ful for a great many years. We believe this statement to be open to much
doubt—turning, in part, on certain disputed interpretations of what the
theory indicated on various key occasions.

OTHER ASPECTS OF SECURITY ANALYSIS

717

Undoubtedly, there are times when the behavior of the market,
as revealed on the charts, carries a definite and trustworthy
meaning of particular value to those who are skilled in its inter¬
pretation. If reliance on chart indications were confined to those
really convincing cases, a more positive argument could be
made in favor of “technical study.” But such precise signals
seem to occur only at wide intervals, and in the meantime human
impatience plus the exigencies of the chart reader's profession
impel him to draw more frequent conclusions from less convincing
data.

4. Other Theoretical and Practical Weaknesses .—The appeal
of chart reading to the stock-market trader is something like that
of a patent medicine to an incurable invalid. The stock specula¬
tor does suffer, in fact, from a well-nigh incurable ailment. The
cure he seeks, however, is not abstinence from speculation but
profits. Despite all experience, he persuades himself that these
can be made and retained; he grasps greedily and uncritically
at every plausible means to this end.

The plausibility of chart reading, in our opinion, derives
largely from its insistence on the sound gambling maxim that
losses should be cut short and profits allowed to run. This
principle usually prevents sudden large losses, and at times it
permits a large profit to be taken. The results are likely to be
better, therefore, than those produced by the haphazard following
of “market tips.” Traders, noticing this advantage, are certain
that by developing the technique of chart reading farther they
will so increase its reliability as to assure themselves continued
profits.

But in this conclusion there lurks a double fallacy. Many
players at roulette follow a similar system, which limits their
losses at any one session and permits them at times to realize
a substantial gain. But in the end they always find that the
aggregate of small losses exceeds the few large profits. (This
must be so, since the mathematical odds against them are inexo¬
rable over a period of time.) The same Is true of the stock
trader, who will find that the expense of trading weights the dice
heavily against him. A second difficulty is that, as the methods
of chart reading gain in popularity, the amount of the loss taken
in unprofitable trades tends to increase and the profits also
tend to diminish. For as more and more people, following the

718

SECURITY ANALYSIS

same system, receive the signal to buy at about the same time,
the result of this competitive buying must be that a higher
average price is paid by the group. Conversely, when this
larger group decides to sell out at the same time, either to cut
short a loss or to protect a profit, the effect must again be that a
lower average price is received. (The growth in the use of
“ stop-loss orders,” formerly a helpful technical device of the
trader, had this very effect of detracting greatly from their
value as a protective measure.)

The more intelligent chart students recognize these theoretical
weaknesses, we believe, and take the view that market forecasting
is an art that requires talent, judgment, intuition and other
personal qualities. They admit that no rules of procedure can
be laid down, the automatic following of which will insure success.
Hence the widespread tendency in Wall Street circles towards a
composite or eclectic approach, in which a very thorough study
of the market’s performance is projected against the general
economic background, and the whole is subjected to the appraisal
of experienced judgment.

The Second Type of Mechanical Forecasting.—Before con¬
sidering the significance of this injection of the judgment factor,
let us pass on to the other type of mechanical forecasting, which
is based upon factors outside of the market itself. As far as the
general market is concerned, the usual procedure is to construct
indices representing various economic factors, e.g., money rates,
carloadings, steel production, and to deduce impending changes
in the market from an observation of a recent change in these
indices. 1 One of the earliest methods of the kind, and a very
simple one, was based upon the percentage of blast furnaces in
operation.

This theory was developed by Col. Leonard P. Ayres of the
Cleveland Trust Company and ran to the effect that security
prices usually reached a bottom when blast furnaces in operation
declined through 60% of the total and that conversely they

1 These indices may also be plotted on charts, in which case the forecasting
takes on the aspect of chart reading. Examples: The A, B and C lines of the
Harvard Economic Service which were published in weekly letters from Jan. 3,
1922, to Dec. 26, 1931 (since continued through 1939 at less frequent inter¬
vals in The Review of Economic Statistics); also the single composite Index
Line in the “Investment Timing Service” offered by Independence Fund
of North America, Inc., in 1939.

OTHER ASPECTS OF SECURITY ANALYSIS 719

usually reached a top when blast furnaces in operation passed
through the 60% mark on the upswing in use thereof. 1 A
companion theory of Colonel Ayres was that the high point in
bond prices is reached about 14 months subsequent to the low
point in pig-iron production and that the peak in stock prices
is reached about two years following the low point for pig-iron
production. 2

This simple method is representative of all mechanical fore¬
casting systems, in that (1) it sounds vaguely plausible on the
basis of a priori reasoning and (2) it relies for its convincingness
on the fact that it has “worked” for a number of years past.
The necessary weakness of all these systems lies in the time
element. It is easy and safe to prophesy, for example, that a
period of high interest rates will lead to a sharp decline in the
market. The question is, “How soon?” There is no scientific
way of answering this question. Many of the forecasting
services arc therefore driven to a sort of pseudo-science, in which
they take it for granted that certain time lags or certain coinci¬
dences that happened to occur several times in the past (or
have been worked out laboriously by a process of trial and error),
can be counted upon to occur in much the same way in the future.

Broadly speaking, therefore, the endeavor to forecast security-
price changes by reference to mechanical indices is open to the
same objections as the methods of the chart readers. They
are not truly scientific, because there is no convincing reasoning
to support them and because, furthermore, really scientific
(i.e.j entirely dependable) forecasting in the economic field is a
logical impossibility.

Disadvantages of Market Analysis as Compared with Security
Analysis. —We return in consequence to our earlier conclusion
that market analysis is an art for which special talent is needed
in order to pursue it successfully. Security analysis is also an
art; and it, too, will not yield satisfactory results unless the
analyst has ability as well as knowledge. We think, however,
that security analysis has several advantages over market

1 See Bulletin of the Cleveland Trust Company , July 15, 1924, cited by
David F. Jordan, in Practical Business Forecasting , p. 203n, New York, 1927.

* See Business Recovery Following Depression , a pamphlet published by
the Cleveland Trust Company in 1922. The conclusions of Colonel Ayres
are summarized on p. 31 of the pamphlet.

720

SECURITY ANALYSIS

analysis, which are likely to make the former a more successful
field of activity for those with training and intelligence. In
security analysis the prime stress is laid upon protection against
untoward events. We obtain this protection by insisting upon
margins of safety, or values well in excess of the price paid. The
underlying idea is that even if the security turns out to be less
attractive than it appeared, the commitment might still prove a
satisfactory one. In market analysis there are no margins of
safety; you are either right or wrong, and, if you are wrong, you
lose money. 1

The cardinal rule of the market analyst that losses should be
cut short and profits safeguarded (by selling when a decline
commences) leads in the direction of active trading. This means
in turn that the cost of buying and selling becomes a heavily
adverse factor in aggregate results. Operations based on
security analysis are ordinarily of the investment type and do
not involve active trading.

A third disadvantage of market analysis is that it involves
essentially a battle of wits. Profits made by trading in the
market are for the most part realized at the expense of others
who are trying to do the same thing. The trader necessarily
favors the more active issues, and the price changes in these
are the resultant of the activities of numerous operators of his
own type. The market analyst can be hopeful of success only
upon the assumption that he will be more clever or perhaps
luckier than his competitors.

The work of the securities analyst, on the other hand, is in
no similar sense competitive with that of his fellow analysts.
In the typical case the issue that he elects to buy is not sold
by some one who has made an equally painstaking analysis of
its value. We must emphasize the point that the security analyst
examines a far larger list of securities than does the market
analyst. Out of this large list, he selects the exceptional cases

1 Viewing the two activities as possible professions, we are inclined to
draw an analogous comparison between the law and the concert stage. A
talented lawyer should be able to make a respectable living; a talented, i.e .,
a “merely talented,” musician faces heartbreaking obstacles to a successful
concert career. Thus, as we see it, a thoroughly competent securities
analyst should be able to obtain satisfactory results from his work, whereas
permanent success as a market analyst requires unusual qualities—or unu¬
sual luck.

OTHER ASPECTS OF SECURITY ANALYSIS

721

in which the market price falls far short of reflecting intrinsic
value, either through neglect or because of undue emphasis laid
upon unfavorable factors that are probably temporary.

Market analysis seems easier than security analysis, and its
rewards may be realized much more quickly. For these very
reasons, it is likely to prove more disappointing in the long run.
There are no dependable ways of making money easily and
quickly, either in Wall Street or anywhere else.

Prophesies Based on Near-term Prospects. —A good part
of the analysis and advice supplied in the financial district rests
upon the near-term business prospects of the company considered.
It is assumed that, if the outlook favors increased earnings, the
issue should be bought in the expectation of a higher price when
the larger profits are actually reported. In this reasoning, secur¬
ity analysis and market analysis are made to coincide. The
market prospect is thought to be identical with the business
prospect.

But to our mind the theory of buying stocks chiefly upon the
basis of their immediate outlook makes the selection of specula¬
tive securities entirely too simple a matter. Its weakness lies
in the fact that the current market price already takes into
account the consensus of opinion as to future prospects. And
in many cases the prospects will have been given more than their
just need of recognition. When a stock is recommended for the
reason that next year’s earnings are expected to show improve¬
ment, a twofold hazard is involved. First, the forecast of next
year’s results may prove incorrect; second, even if correct, it may
have been discounted or even overdiscounted in the current price.

If markets generally reflected only this year’s earnings, then a
good estimate of next year’s results would be of inestimable value.
But the premise is not correct. Our table on page 723 shows on
the one hand the annual earnings per share of United States Steel
Corporation common and on the other hand the price range of
that issue for the years 1902-1939. Excluding the 1928-1933
period (in which business changes were so extreme as necessarily
to induce corresponding changes in stock prices), it is difficult to
establish any definite correlation between fluctuations in earnings
and fluctuations in market quotations.

In the Appendix, Note 70, we reproduce significant parts of the
analysis and recommendation concerning two common stock*

722

SECURITY ANALYSIS

made by an important statistical and advisory service in the
latter part of 1933. The recommendations are seen to be based
largely upon the apparent outlook for 1934. There is no indica¬
tion of any endeavor to ascertain the fair value of the business
and to compare this value with the current price. A thorough¬
going statistical analysis would point to the conclusion that the
issue of which the sale is advised was selling below its intrinsic
value, just because of the unfavorable immediate prospects, and
that the opposite was true of the common stock recommended as
worth holding because of its satisfactory outlook.

We are sceptical of the ability of the analyst to forecast with
a fair degree of success the market behavior of individual issues
over the near-term future—whether he base his predictions upon
the technical position of the market or upon the general outlook
for business or upon the specific outlook for the individual com¬
panies. More satisfactory results are to be obtained, in our
opinion, by confining the positive conclusions of the analyst to
the following fields of endeavor:

1. The selection of standard senior issues that meet exacting tests of
safety.

2. The discovery of senior issues that merit an investment rating but
that also have opportunities of an appreciable enhancement in value.

3. The discovery of common stocks, or speculative senior issues, that
appear to be selling at far less than their intrinsic value.

4. The determination of definite price discrepancies existing between
related securities, which situations may justify making exchanges or initiat¬
ing hedging or arbitrage operations.

A SUMMARY OF OUR VIEWS ON INVESTMENT POLICIES

If we transfer our attention, finally, from the analyst to the
owner of securities, we may briefly express our views on what
he may soundly do and not do. The following rdsum6 makes
some allowance for different categories of investors.

A. The Investor of Small Means. 1. Investment for Income .—
In his case the only sensible investment for safety and accumulated
income , under present conditions ) is found in United States Savings
Bonds. Other good investments yield little if any more, and they
have not equal protection against both ultimate and intermediate
loss. Straight bonds and preferred stocks ostensibly offering a
higher return are almost certain to involve an appreciable risk
factor. The various types of "savings plans” and similar

OTHER ASPECTS OF SECURITY ANALYSIS

723

United States Steel Common, 1901-1939

Year

Earned per share

Range of market price

HigR

Low

Average

1901

$ 9.1

1902

10.7

1903

4.9

1904

1.0

1905

8.5

1906

14.3

1907

15.6

1908

4.1

1909

10.6

1910

12.2

1911

5.9

1912

5.7

1913

11.0

1914

0.3(d)

1915

10.0

1916

48.5

130

105

1917

39.2

137

109

1918

22.1

117

102

1919

10.1

116

102

1920

16.6

109

1921

2.2

1922

2.8

112

1923

16.4

110

1924

11.8

121

108

1925

12.9

139

112

126

1926

18.0

161

117

139

1927*

12.3

246

155

201

19271

8.8

176

111

144

1928

12.5

173

132

153

1929

21.2

262

150

206

1930

9.1

199

134

167

1931

i.m

152

1932

11,1(d)

1933

7.1(d)

1934

B.m

1935

2.8(d)

1936

2.9

1937

8.0

127

1938

8.8(d)

1939

1.84

+ Before allowing for 40 % stock dividend,
t After allowing for 40 % stock dividend.

724

SECURITY ANALYSIS

securities offered by salesmen are full of pitfalls; the investor
persuaded by their promise of liberal income to prefer them to
United States Savings Bonds is very, very likely to regret his
choice.

2. Investment for Profit .—Four approaches are open to both
the small and the large investor:

a. Purchase of representative common stocks when the market
level is clearly low as judged by objective, long-term standards.
This policy requires patience and courage and is by no means
free from the possibility of grave miscalculation. Over a long
period we believe that it will show good results.

b. Purchase of individual issues with special growth possi¬
bilities, when these can be obtained at reasonable prices in rela¬
tion to actual accomplishment.

Where growth is generally expected, the price is rarely reason¬
able. If the basis of purchase is a confidence in future growth
not held by the public, the operation may prove sound and
profitable; it may also prove ill-founded and costly.

c. Purchase of well-secured privileged senior issues. A com¬
bination of really adequate security with a promising conversion
or similar right is a rare but by no means unknowm phenomenon.
A policy of careful selection in this field should bring good results,
provided the investor has the patience and persistence needed to
find his opportunities.

d. Purchase of securities selling well below intrinsic value.
Intrinsic value takes into account not only past earnings and
liquid asset values but also future earning power, conservatively
estimated—in other words, qualitative as well as quantitative
elements. We think that since a large percentage of all issues
nowadays are relatively unpopular, there must be many cases in
which the market goes clearly and crassly astray, thus creating
real opportunities for the discriminating student. These may be
found in bonds, preferred stocks and common stocks.

In our view, the search for and the recognition of security
values of the types just discussed are not beyond the competence
of the small investor who wishes to practice security analysis in a
nonprofessional capacity, although ho will undoubtedly need
better than average intelligence and training. But we think it
should be a necessary rule that the nonprofessional investor
submit his ideas to the criticism of a professional analyst, such

OTHER ASPECTS OF SECURITY ANALYSIS

725

as the statistician of a New York Stock Exchange firm. Surely
modesty is not incompatible with self-confidence; and there is
logic in the thought that unless a man is qualified to advise others
professionally, he should not, unaided, prescribe for himself.

3. Speculation .—The investor of small means is privileged, of
course, to step out of his role and become a speculator. (He is also
privileged to regret his action afterwards.) There are various
types of speculation, and they offer varying chances of success:

a. Buying stock in new or virtually new ventures. This we
can condemn unhesitatingly and with emphasis. The odds are
so strongly against the man who buys into these new flotations
that he might as well throw three-quarters of the money out of
the window and keep the rest in the bank.

b. Trading in the market. It is fortunate for Wall Street as
an institution that a small minority of people can trade success¬
fully and that many others think they can. The accepted view
holds that stock trading is like anything else; i.e ., with intelli¬
gence and application, or with good professional guidance, profits
can be realized. Our own opinion is sceptical, perhaps jaundiced.
We think that, regardless of preparation and method, success
in trading is either accidental and impermanent or else due to a
highly uncommon talent. Hence the vast majority of stock
traders are inevitably doomed to failure. We do not expect
this conclusion to have much effect on the public. (Note our
basic distinction between purchasing stocks at objectively low
levels and selling them at high levels—which we term invest¬
ment—and the popular practice of buying only when the market
is “expected” to advance and selling when it is “due” to decline—
which we call speculation.)

c. Purchase of “growth stocks” at generous prices. In
calling this “speculation,” we contravene most authoritative
views. For reasons previously expressed, we consider this
popular approach to be inherently dangerous and increasingly
so as it becomes more popular. But the chances of individual
success are much brighter here than in the other forms of specula¬
tion, and there is a better field for the exercise of foresight,
judgment and moderation.

B. The Individual Investor of Large Means. —Although he has
obvious technical advantages over the small investor, he suffers
from three special handicaps:

726

SECURITY ANALYSIS

1. He cannot solve his straight investment problem simply by
buying nothing but United States Savings Bonds, since the
amount that any individual may purchase is limited. Hence he
must, perforce, consider the broader field of fixed-value invest¬
ment. We believe that strict application of quantitative tests,
plus reasonably good judgment in the qualitative area, should
afford a satisfactory end result.

2. However, the extraneous problem of possible inflation is
more serious to him than to the small investor. Since 1932 there
has been a strong common-sense argument for some common-
stock holdings as a defensive measure. In addition, a substantial
holding of common stocks corresponds with the traditional
attitude and practice of the wealthy individual.

3. The size of his investment unit is more likely to induce the
large investor to concentrate on the popular and active issues.
To some extent, therefore, he is handicapped in the application
of the undervalued-security technique. However, we imagine
that a more serious obstacle thereto will be found in his pref¬
erences and prejudices.

C. Investment by Business Corporations. —We believe that
United States government bonds, carrying exemption from
corporate income taxes, are almost the only logical medium for
such business funds as may properly be invested for a term of
years. (Under 1940 conditions short-time investment involves
as much trouble as income.) It seems fairly evident, on the
whole, that other types of investments by business enterprises—
whether in bonds or in stocks—can offer an appreciably higher
return only at risk of loss and of criticism.

D. Institutional Investment. —We shall not presume to suggest
policies for financial institutions whose business it is to be versed
in the theory and practice of investment. The same might be
said for philanthropic and educational institutions, since these
generally have the benefit of experienced financiers in shaping
their financial policies. But in order not to dodge completely a
very difficult issue, we venture the following final observation:
An institution that can manage to get along on the low income
provided by high-grade fixed-value issues should, in our opinion,
confine its holdings to this field. We doubt if the better per¬
formance of common-stock indexes over past periods will, in
itself, warrant the heavy responsibilities and the recurring uncer-

OTHER ASPECTS OF SECURITY ANALYSIS

727

taintie8 that are inseparable from a common-stock investment
program. This conclusion may perhaps be modified cither if
there is substantial unanimity of view that inflation must be
guarded against or if the insufficiency of income compels search
for a higher return. In such case those in charge may be war¬
ranted in setting aside a portion of the institution’s funds for
administration in other than fixed-value fields, in accordance
with the canons and technique of security analysis. 1

1 Yale University now follows a policy of investing part of its funds in
“equities”—defined as common stocks and nonpaying senior issues. The
percentage varies in accordance with a fixed formula, somewhat as follows:
The initial proportion is 30 % of the total fund. Whenever a rise in the
market level advances this figure to 40 %, one-eighth of each stock holding
is switched into bonds. Conversely, whenever a decline in the market
reduces the proportion to 15%, bonds are sold and one-third additional
of each stock is bought. See address of Laurence G. Tighe, Associate
Treasurer of Yale University entitled “Present Day Investment Problems
of Endowed Institutions,” delivered on February 14, 1940 before the Trust
Division of the American Bankers Association. It was summarized in the
New York Sun of February 20,1940.

APPENDIX

NOTE 1 (page 14 of text)

Abbott Laboratories

Year

Price of stock 1

Earned

Paid

High

Low

per share 1 j

per share 1

1929

$1.17

$0.36

1930

0.80

0.57

1931

0.67

0.60

1932

0.50

0.54

1933

0.90

0.48

1934

1.48

0.56

1935

1.77

0.95

1936

2.10

1.97

1937

2.38

2.00

1938

2 31

1.62

1939

2 61*

2.05

1 Figures adjusted to reflect situation at end of 1939 by allowing for 33H %, 200% and
5 % stock dividends paid in 1933, 1936 and 1939, respectively.

* Earnings on average number of shares outstanding in 1939 were about $2.90 per share.

American Home Products Corporation

Year

Price of stock

Earned per
share

Paid per
share

High

Low

$5 47

$3.55

5.49

4.20

1931

5.52

4.20

Msm

3.93

4.20

2.97

3.25

1934

3.02

2.40

1935

2.57

2.40

1936

3.81

2.50

1937

3.88

2.60

1938

3.75

2.40

1939

5.23

2.65

720

730

SECURITY ANALYSIS

The Lambert Company

Year

Price of stock

Earned per
share

Paid per
share

High

Low

1926

$4.58

$1.75

1927

6.98

6.00

1928

136

8.92

6.50

1929

157

10.04

7.75

1930

113

9.52

8.00

1931

8.23

8.00

1932

5.08

7.00

1933

2.99

4.00

1934

2.96

3.00

1935

2.03

2.75

1936

1.70

2.00

1937

1.54

2.00

1938

1.71

1.50

1939

1.69

1.50

NOTE 2 (page 20 of text)

The ’Frisco 6% Preferred declined to 4% in 1931 and to $1 per share in
1932, the year in which the road went into receivership. The issue is to
be wiped o\it under the I.C.C. examiner’s plan of reorganization for the road.

The Owens-Illinois Glass Co. bonds were called the very next year
(July 1933) at 10134-

Wright Aeronautical stock rose to 32% in 1925 and spectacularly to 299
in 1929 prior to a 100% stock-dividend payment in that year. The new
stock collapsed to 3% in 1932 (equivalent to 7% on the old basis). It
recovered in a manner suggestive of manipulation to 140% in 1936 (equiva¬
lent to 281% on the old basis), a price that it proved unable to regain
in 1939 despite greatly increased earnings due to war orders. A sharply
rising trend of earnings for the years 1935-1939, coupled with booked and
prospective war business, may account for the fact that the stock at the end
of 1939 was selling at thirty-five times the average earnings for 1935-1939.

In the ensuing six years the I.R.T. Notes received 7% annually on
account of interest and almost 1.7% annually applied against principal.
In 1939 the city of New York contracted to purchase the I.R.T. properties
on terms to realize 87%% of the unpaid principal for the noteholders and
82%% of the principal of the 5% bondholders, payable in 3% New York
City bonds (Corporate Stock). In our view the ample collateral behind
the notes entitled them to repayment at par. Nevertheless, the buyer of the
7s in 1933 would have fared substantially better than a purchaser of the
6s at the same price. Assuming payment in New York City bonds worth
par, the total received by the noteholders, including interest, would be about
$1,340 per $1,000 note against about $1,125 per 5% bond.

APPENDIX

731

Paramount Pictures paid SI2 of accumulated dividends on the First
Preferred in December 1936. It has continued to pay dividends regularly
on that issue since, but paid no dividends on the common until 1939.
Early in 1937 both the First Preferred and common enjoyed a substantial
rise in price, but later in the year the Preferred sold at a substantial premium
over the common—a condition that has generally prevailed since then.

NOTE 3 (page 29 of text)

“CHEAP STOCKS” vs. “DEAR STOCKS”

An effort was made in 1936 and 1938 under the direction of the authors to
test the relative performance of stocks selling at a high multiple of the
previous year's earnings and those selling at a low multiple of such earnings.
Eight separate studies were made, as of March 1 in each year from 1924
through 1931. All the industrial shares listed on the New York Stock
Exchange were arranged in order of the ratio of the March 1 price to the
previous year's earnings. (Companies with fiscal years not ending on
December 31 and those earning less than $1 per share in the previous year
were excluded.) Of the remaining companies the top and bottom quartiles
were then taken for subsequent comparison. On the average, the top
quartile sold originally about three times as high in relation to earnings as
did the bottom quartile.

The factors studied included later changes in market price and the ensuing
record of earnings and dividend payments. We sought to determine
whether the buyer of the high-multiple (“dear”) or low-multiple (“cheap”)
stocks would fare better with respect to (1) future price changes plus divi¬
dend receipts and (2) future earnings in relation to price paid. Tests were
made as of March 1 of each year following the initial date selected.

To save space the detailed results of our study are not given here. On
the whole they are inconclusive, in that they do not point to a consistent
advantage enjoyed by one group or the other. Such inferences as can be
drawn favor the stocks selling at the low multiple of the previous year's
earnings. Although the dear stocks later improved their earnings and
dividends as against the cheaper group—which was to be expected—this
improvement docs not seem to be great enough (over an eight-year period)
to offset the initial premium paid for these issues. Nor was their better
showing sufficiently sustained, in good and bad years, to make certain that
they would eventually prove cheaper than the cheap stocks.

Acknowledgments are due Mr. Irving Kahn for his aid in this study.

NOTE 4 (page 70 of text)

A part of the financial history of the U. S. Express Co. shows how the
conversion of an interest in property from the stock form to the bond form
obtained buyers for the new securities which were both less safe tmd less
profitable than the stock issue.

In 1918 the sole assets of the company consisted cf a building at 2 Rector
Street, New York City, and miscellaneous real estate of relatively slight
value. Ownership of these assets was represented by 100,000 shares of

732

SECURITY ANALYSIS

stock selling at $15 per share. The following year the Rector Street building
was sold for $3,725,000, the buyer financing the purchase in part by the sale
at par of $3,000,000 first-mortgage bonds secured by a lien on the building.
After disposing of its other assets, U. S. Express Co. paid liquidating divi¬
dends to its shareholders of $39.25 per share.

There is a striking contrast between the essential merits of the U. S.
Express Co. stock at 15 and of these bonds at par. Buyers of the former
were paying the equivalent of $1,500,000 for complete ownership of the
Rector Street property, plus the other assets. Buyers of the latter were
paying $3,000,000 for a limited interest in the Rector Street property alone.
Obviously the stock at 15 was both a safer and a more attractive commit¬
ment than the bonds were at par. Apparently the public regarded the
stock as a speculation and the bonds, representing only a part interest in the
assets behind the stock, as an investment. A part of the explanation of
this anomaly probably lay in the magic influence of the title “bond.”

For a more detailed statement of this example, with source references, see
pp. 617-618 of the 1934 edition of this work.

A more recent illustration of this principle is afforded by the history of the
Court-Livingston Office Building in Brooklyn. After foreclosure of the
original first mortgage, ownership of the property (except as to certain
leased land) was represented by 3,880 shares of stock. Early in 1939 the
stock was quoted at $30 per share, indicating a total value of $116,400 for
the company's assets. At that time, however, it held about $180,000 in
cash. In April 1939 the property was sold for $250,000, and the stock¬
holders later received about $110 per share in liquidation of their interest.
The buyer placed a mortgage of $285,000 with a savings bank, covering the
entire property including the land formerly leased. The rental obligation
existing with respect to part of the plot makes this example less clear-cut
than the U. S. Express building case. But the fact that the Court-Living¬
ston stock sold for much less than the applicable cash holdings shows the
extraordinary undervaluation resulting from the use of the stock form under
conditions in which the bond form is the usual and expected medium of
financing.

NOTE 5 (page 76 of text)

“American Certificates” representing $5.30 par value (at then current
rates of exchange) of Kreuger and Toll Co. Participating 5% Debentures,
due optionally in 2003, were sold in the American market at $28.14 each.
The following features justified classification of the issue as of the common-
stock type:

1. The underlying Debentures bore interest at 5%, payable annually,
and were entitled to additional interest at the rate of 1 % for each 1 % by
which the dividend paid or declared on the ordinary shares in any fiscal
year exceeded 5%.

2. The issue price of the “American Certificates” was 5)4 times the par
value of the related Debentures. At the regular (i.e., the nonparticipating)
interest rate of 5% the yield on the offering price would be less than 1%,

APPENDIX

733

3. The owner was dependent for a reasonable income upon the partici¬
pating feature of the Debentures, and this in turn was governed by the
dividend paid on the stock. Only about one-fifth of the income and principal
value of this security could bo ascribed to the bond contract; the remaining
four-fifths had all of the contingent and variable features of a common-stock
commitment. This division may be set forth as follows:

(Per unit of 20 Kroner)

Item

Bond

component

Stock

component

Total

Principal.

$5.36

$28.14

Income in 1928. ... .

0.27

1.34

These certificates sold as high as 46% in 1929 and at % cent in 1934.

NOTE 6 (page 77 of text)

Convincing evidence of the investment character of National Biscuit Co.
Preferred is found in the price history and dividend record of the issue.
The annual dividend of $7 per share has been paid regularly since organiza¬
tion of the company in 1898. The issue has not sold below par ($100) since
1907. The average of the annual high and low prices for 1908-1939 was
140.6, on which the annual dividend of $7 has yielded 5%. A similar
average for the entire history of the issue on the New York Stock Exchange
(1899-1939) is 132.75 and a yield of 5.27%. This average covers a range of
79% in 1900 and 175 in 1939. In only five out of the forty-one years since
the issue was first listed has it sold at a price below par.

NOTE 7 (page 81 of text)

Twenty-five million dollars of Seaboard-All Florida Railway First Mort¬
gage 6% Gold Bonds, Series .4, due Aug. 1, 1935, were originally offered in
1925 at 98% and interest. The bonds were joint and several obligations of
the Seaboard-All Florida Ry., Florida Western & Northern R.R. Co., and the
East & West Coast Ry. They were further secured by an unconditional
guarantee with respect to both principal and interest, through endorsement
by the Seaboard Air Line Ry. Co., which leased the properties of the several
roads at a minimum annual net rental equal to the annual interest charges
on all bonds outstanding under the mortgage.

The proceeds from the sale of these bonds were used mainly to redeem
outstanding first-mortgage obligations of the lessor roads and to construct
about 217 miles of new trackage along the east and west coasts of Florida.
Thus the bonds had a first lien on approximately 475 miles of newly con¬
structed and established lines.

The Seaboard-All Florida Ry. went into the hands of receivers on Feb. 2,
1931, following receivership for the Seaboard Air Line Ry. Co. and a default
in interest due on these bonds.

734

SECURITY ANALYSIS

Although the buyers of these bonds provided $24,625,000 to defray the
cost of acquiring and constructing Florida railway properties, by December
1931 their bonds were selling as low as 1 cent on the dollar, the market
appraising the value of their investment at only $250,000. At the end of
1939 the appraisal had risen to $940,000, or 3.875 cents on the dollar.

NOTE 8 (page 82 of text)

Interest was defaulted on Bush Terminal Co. First Mortgage 4s, due
1952, and on the company's Consolidated Mortgage 5s, due 1955, in 1933.
There were also defaults on sinking fund payments. All defaults were
remedied during the reorganization proceedings, and the issues emerged
undisturbed. Several other examples of this comparatively rare treatment
of defaulted issues are given on pp. 637-638 of the 1934 edition of this work.

NOTE 9 (page 82 of text)

Principal and interest were defaulted on Chicago & Eastern Illinois R.R.
Co., First Consolidated 6s, due Oct. 1, 1934, in 1934 and 1935, respectively.
The plan of reorganization consummated in 1940 provided for their payment
in cash at par and interest at 4 % to date of payment.

Price Bros. Co., Ltd., First Mortgage 6s due 1943 were defaulted as to
interest in 1932. In 1937 the holders received par and accrued interest to
the date of payment.

Other examples are given on p. 638 of the 1934 edition of this work.

NOTE 10 (page 82 of text)

The Missouri, Kansas & Texas Ry. Company went into the hands of
receivers in 1915. Prior thereto the First 4s of 1990 had sold as high as
104J4 in 1905 and as late as 1914 had sold at 91 %. Before the financial
difficulties leading to the 1915 receivership, the record of this issue was
distinctly that of a high-grade, investment bond. During the eleven years
1903 to 1912, inclusive, the lowest price at which it sold was 98% (in the
panic year 1907).

During the protracted receivership interest payments were deferred and
the bonds were traded “flat" in the market. Although technical default
was avoided, the investment status of the issue disappeared, the bonds
selling as low as 52% during the receivership. In 1921 when the plan of
reorganization was announced, the bonds sold as low as 56, and it was not
until 1927 that they regained a semblance of their former prestige as an
investment issue by selling above 90. Thus the first lien did not protect
the holder from a substantial market decline during the period of financial
difficulty.

The same sort of picture is presented by the record of Brooklyn Union
Elevated R.R. First 5s, due in 1950, described in Chap. II of the text. This
was an underlying lien on essential parts of the elevated lines of the Brooklyn
Rapid Transit Co. which went into the hands of receivers on Dec. 31, 1918
and was reorganized as the Brooklyn-Manhattan Transit Corp. in 1923.

APPENDIX

735

The issue ranked as a first-grade investment from 1903 to 1917 and never
sold below 90 during this period, except in the panic of 1907 when it dropped
to 85, and in 1917 when the receivership appeared imminent. Although the
issue was not disturbed by the reorganization, it sold as low as 65 in 1920,
while the receivership was still in effect, and did not regain its former
standing until 1926, three years after the termination of the receivership.

Choctaw & Memphis R.R. First Mortgage 5s, due 1949, defaulted as to
interest on July 1, 1934. In 1938 and 1939 the low bids were 21 and 32,
respectively. But the reorganization plan for the Chicago, Rock Island &
Pacific Ry. Co. provides substantially for their emergence undisturbed as a
small underlying issue of the system. (See discussion of this issue on
p. 699.)

NOTE 11 (pages 96 and 280 of text)

PRICE PERFORMANCE OF RAILROAD AND PUBLIC-UTILITY BONDS
IN 1937-1938 AS RELATED TO EARNINGS COVERAGE IN 1936

A. Railroad Bonds:

The bonds of 37 railroads listed on the New York Stock Exchange and
not in receivership in January 1937 were classified according as they earned
their fixed charges more than 2H times or less than twice in 1936. (Only the
Atchison and Bangor & Aroostook earned their charges between 2 and 2}£
times.) For each road an active issue was taken representing the most
junior lien. The following table reflects the average performance of the
bonds falling in three categories:

Total
interest
earned in
1936

Average per $1,000 bond

Item

Coupon

rate

1937-1938

High

price

Low

price

Class I:

7 dividend-paying roads, interest
earned over 2}£ times.

4.68 times

4.04%

112K

ioo?4

Class II:

12 dividend-paying roads, inter¬
est earned less than twice.

1.50 times

4.56%

105?4

Class III:

18 nondividend roads, interest
earned less than twice.

1.17 times

4.44%

9354

29H

Only one bond issue in Class I declined more than 10%. (It was the
Chesapeake & Ohio General 4J^s, due 1992, which later recovered nearly all
its loss.)

736

SECURITY ANALYSIS

B. Public-utility Bonds:

All the solvent public-utility companies with bonds listed on the New
York Stock Exchange were classified according as 1930 fixed charges were
covered less than 1% times, between 1% times and twice, and more than
twice. The following compilation shows the comparative performance of
the companies in the first and third classes, each company being represented
by one important bond issue.

Total

interest

earned

1936

Average per SI,000 bond

Item

Coupon

rate

1937-

-1938

High

price

Low

price

Class I:

42 companies earning 1936 inter¬
est more than twice.

3.67 times

3.93%

108%

102%

Class II:

11 companies earning 1936 inter¬
est less than 1 % times.

1.29 times

5.16%

90%

61%

Of the 42 issues in Class I, only 5 declined more than 10%. All these
later recovered to within three points of their 1937 high, or better. Of the
11 issues in Class II only 1 failed to decline more than 10%. This was the
obligation of Saguenay Power Co., which is controlled by Aluminium Ltd.
of Canada and enjoys certain guarantees by the powerful Aluminum Co.
of America.

NOTE 12 (page 96 of text)

For more complete details concerning the following examples see pp.
640-641 of the 1934 edition of this work.

1. Gulf States Steel Co., which sold an issue of 5%% Debentures in
1927 at 98% and further bonds of the same issue in 1930, covered the 1929
charges thereon an average of 4.88 times in 1922-1929. The minimum
coverage during that period was 3% times in 1926. But the company
operated at a deficit before interest charges in 1930-1932, and the bonds
declined to a low of 21 in 1932.

2. Marion Steam Shovel Co., which in 1927 sold an issue of First 6s,
due 1947, at 99%, covered the charges thereon an average of 4.11 times in
1922-1929. The minimum coverage during that period was 2.78 times in
1928. But in seven of the ensuing nine years the company operated at a
deficit before interest charges, and the bonds sold as low as 20 cents on the
dollar.

3. McCrory Stores Corp., which sold an issue of Debenture 5%s at 98
in 1926, covered all its 1931 fixed charges an average of 5.32 times in the

APPENDIX

737

decade 1922-1931. Earnings declined sharply thereafter, and the com¬
pany failed to earn its charges. In 1933 the company was petitioned into
bankruptcy, and the bonds sold as low as 21%.

All three of these issues, however,, recovered all or most of their price
decline in subsequent years.

NOTE 13 (pages 97 and 280 of text)

PRICE PERFORMANCE OF INDUSTRIAL BONDS IN 1937-1938, AS

RELATED TO EARNINGS FOR A PERIOD OF YEARS ENDED

IN 1936

This study is similar to the one described in Appendix Note 11, with the
following modifications: All the industrial bonds listed on the New York
Stock Exchange were examined with respect to average earnings coverage for
as many years as possible through 1936 (not more than 10). In Group A
were placed all the companies (27 in number) that showed a coverage of
better than three times interest charges. In Group B were placed the 37
companies that covered charges less than 2% times.

Average results for the two groups were as follows:

Item

Number
of issues

Median 1

interest

coverage

Coupon

rate

Price range
1937-1938

High

Low

Group A. ..

Group B .

4.00 times
1.45 times

4.07%

5.00%

107^

97 M
70

1 Median figure used, since average would be nonrepresentative.

Only eight issues in Group A lost more than 10% of their maximum
market price, and only nine issues in Group B failed to suffer this percentage
decline. Of these eight bonds in Group A } all but two (Gotham Silk
Hosiery 5s and Jones & Laughlin 4}^s) later recovered to within four points
of the 1937 high. Of the nine bonds in Group B that maintained their
price, all but two (Houston Oil 5%s and Koppers Co. 4s) had earned their
interest better than three times in the single year 1936.

NOTE 14 (page 97 of text)

See pp. 641-643 of the 1934 edition of this work for fuller details con¬
cerning the following examples of predepression collapses in earnings power:

1. Botany Consolidated Mills, Inc., First 6Jis, due 1934, were issued in
1924. Net available for the charges thereon in that year and in the seven
preceding years averaged close to 5% times the charges, and the bonds sold
at fixed-value prices until 1926 when the company suffered an operating
deficit. Thereafter (with an insignificant exception in 1927) large and
growing operating deficits were shown until receivership overtook the
company in 1932. In the latter year the bonds sold at 5 cents on the

738

SECURITY ANALYSIS

dollar. They had sold as low as 59 and 40, respectively, in the prosperous
years 1928 and 1929.

2. R. Hoe & Co. First 6Hs» due 1934, were issued in 1924. Average
earnings in the preceding three years were 3.2 times the sum of interest
charges on the new bonds and other fixed charges, without allowance for
any earnings from the new capital raised by the issue. Earnings declined
in 1924 and continued to decline in the ensuing years with the exception of
1929. Nonetheless, the bonds continued to sell close to par, despite inade¬
quate coverage, until 1928. Thereafter they declined to as low as 75 in
1929. In 1932 receivership intervened, and the bonds sold as low as

3. Long-Bell Lumber Corp. showed an almost uninterrupted decline in
net earnings for the period 1922-1932. When Long-Bell Lumber Co. (a
subsidiary) sold First Mortgage 6s in 1926, average coverage was well above
the minimum required for industrial exhibits. But average coverage for
1926-1929 was only 1.37 times, and the company exhibited operating
deficits thereafter until default on the bonds in 1932.

4. National Radiator Corp. Debenture 6J^s, due 1947, were offered at
par in 1927. Available earnings in 1922-1926 had averaged 3.5 times the
charges on the bonds, without allowing for additional earnings on the new
capital. Coverage of fixed charges was adequate in 1927; but operating
deficits were encountered in the ensuing three years, and receivers were
appointed in 1931.

NOTE 16 (page 113 of text)

For earlier examples note: Mexican Light & Power Co. First 5s, due in
1940, were not in default in June 1933 and were selling at 50, whereas the
issues of the Republic of Mexico listed on the New York Stock Exchange
were all in default and were selling at from 4 to 6 cents on the dollar at that
time; Chile Copper Co. Debenture 5s, due in 1947, were selling at 67 in June
1933, whereas the Republic of Chile 6s were in default since 1931 and were
selling at prices ranging from 11 to 12 cents on the dollar; Rio de Janeiro
Tramway, Light & Power Co. First 5s, due in 1935, were at 87 in June 1933,
whereas the bonds of the City of Rio de Janeiro were in default since 1931
and were selling at 22, having sold below 10 cents on the dollar earlier in the
year; Pirelli Co. of Italy Sinking Fund Convertible 7s, due 1952, were selling
above par in June 1933, whereas the Kingdom of Italy External Sinking
Fund 7s, due in 1951, were selling at 95, neither issue being in default.

At the end of 1939 the Mexican Light & Power Co. issue was still paying
its interest charges and selling at 21-25, whereas the Mexico Government
issues were in default and selling at % cent on the dollar. Note also that
in September 1939 Rhine-Westphalia Electric Power Corp. called at par
and interest the small balance of 7% Secured (dollar) Notes when the
German Republic External 7s were selling in the New York market at less
than 10% of par. In November 1939 Pirelli Co. of Italy called for payment
at 105 and interest the entire issue of its 7 % convertible (dollar) bonds, due
in 1952. Concurrently Kingdom of Italy External 7s, due 1951, were
selling at 65.

APPENDIX

739

NOTE 16 (page 113 of text)

For example, the Sept. 1, 1932 coupon on Alpine-Montan Steel Corp.
First 7s, due in 1955, was not paid because of foreign exchange restrictions
imposed by the Austrian government, although the corporation possessed
sufficient domestic funds to make the payment. The Aug. 1, 1932 coupon
on Rima Steel Corp. First 7s, due 1955, was not paid owing to a decree of the
Hungarian government suspending payments abroad in foreign currencies
on Hungarian financial obligations, from and after Dec. 23, 1931. The
principal of Deutsche Bank 6% Notes, due Sept. 1, 1932, was not paid at
maturity owing to exchange restrictions imposed by the German govern¬
ment. Holders were offered immediate payment in marks to be left in
4 Germany or payment on Sept. 1, 1935 in dollars with an immediate pay¬
ment of a cash premium of 2% in dollars. A similar compromise was
worked out with respect to Saxon Public Works, Inc., 5% Notes due July 15,
1932.

NOTE 17 (page 135 of text)

For a detailed treatment of the investment qualities and record of equip¬
ment-trust obligations the student is referred to Kenneth Duncan, Equip -
merit Obligations , Chap. VII, New York, 1924. A case history of defaults
on equipment obligations and their treatment in railroad reorganizations
since 1900 will be found at pp. 229-239 of this excellent treatise. To quote
briefly from Duncan, writing in 1924 (pp. 199-200), “In only three instances
has it been necessary for the holders of equipment securities to accept a
compromise in the form of receiving other securities instead of cash, in
only two instances did they have to retake the equipment and sell it, and
in no case did payment finally fail to be made, cither in cash or in other
securities which could later have been sold for as much as the principal of
the equipment obligations on which default has occurred/' See also A. S.
Dewing, A Study of Corporation Securities , Chap. IX, New York, 1934.

A briefer but more recent synopsis of the treatment of equipment obliga¬
tions in railroad receiverships is reproduced below from a study by Freeman
& Co., specialists in equipment obligations, which was published on Jan. 9,
1940.

RECORD OF EQUIPMENT TRUST ISSUES IN RAILROAD
RECEIVERSHIPS FROM 1886 TO DATE

1886 —Denver Rio Grande R.R. Notes exchanged with bondholders consent
for mortgage bonds and preferred stock which later were worth
forty per cent more than Equipment Trust.

1888— Chesapeake & Ohio . Equipments undisturbed—interest rates on
other securities reduced.

1892— Central Railroad & Banking Co . of Georgia . Undisturbed—paid in
full.

1892— Savannah , Americas & Montgomery. Undisturbed—paid in full.

1892— Toledo St. Louis <& Kansas City R.R. Undisturbed—paid in full.

740

SECURITY ANALYSIS

1896— Atchison Topeka & Santa Fe. Receiver reserved $1,200 mortgage
bond to retire each $1,000 Equipment at maturity.

1895— New York , Lake Erie & Western. Receiver certificates issued to pay
Equipments.

1895— Union Pacific . Undisturbed—mortgage bonds reserved to pay

Equipments at maturity.

1896— Philadelphia & Reading. Equipments paid—partly by assessment.
1896— Northern Pacific. Undisturbed—paid regularly.

1899— Columbus Hocking Valley & Toledo Ry. Interest paid promptly and

10 per cent of principal retired regularly in accordance with new
agreement.

1900— Kansas City, Pittsburgh & Gulf. New first mortgage bonds issued

to pay Equipments.

1905— Cincinnati , Hamilton & Dayton. Undisturbed.

1905— Pere Marquette. Undisturbed—sold additional Equipment Trusts
during receivership to yield 6%.

1908— Seaboard Air Line. Receivers certificates sold to pay off maturing
Equipments.

1908— Detroit , Toledo & Ironton. Full recovery of principal except for
deduction of legal fees and expenses.

1910— Buffalo & Susquehanna. Equipment sold; no loss.

1915— Wabash Railroad. Option of cash or 6% Equipment Trusts.

1916— Minneapolis & St. Louis. Paid in full—undisturbed.

1916— Missouri Pacific —Paid in full—undisturbed.

1916— New Orleans Texas & Mexico. Paid in full—undisturbed.

1916— St. Louis-San Francisco. Paid in full—undisturbed.

1916— Western Pacific. Paid in full—undisturbed.

1916— Wheeling Lake Erie. Paid in full—undisturbed.

1917— Wabash Pittsburgh Terminal. Paid in full—undisturbed.

1918— Chicago Peoria & St. Louis . Temporary default; payment resumed

in 1919.

1920— Washington Virginia R.R. New management paid all arrears.

1921— Missouri Kansas Texas. Paid in full—undisturbed.

1921— Atlanta Birmingham & Atlantic. Cash offering in settlement.

1922— Chicago & Alton. Paid in full—undisturbed.

1923— Minneapolis & St. Louis. Still in receivership—full payment being

made.

1927— Chicago Milwaukee & St. Paul. Paid in full—undisturbed.

1931— Wabash Railway. After a 3-year extension to certain maturities,
interest having been paid in full, in 1939 R.F.C. loan provided
for retirement by purchase of all the then outstanding certificates
maturing up to 1944.

1931— Florida East Coast Railway. After extension of certain maturities, all
equipment trust certificates and interest have been paid in full
to current date. Exception: Series “D” lease disaffirmed.

1931— Seaboard Air Line Railway. All Equipment Trust Certificates
exchanged for Receivers Certificates due February 1, 1945, having
an interest rate of 2% to February 1, 1938, 3% to February 1,

APPENDIX 741

1940, and thereafter 3H% to maturity. Recent issues of equip¬
ment trust certificates being regularly serviced by Receivers.

1931— Ann Arbor. Principal and interest paid in full.

1932— Mobile <& Ohio. Principal and interest being paid in full.

1932— Central of Georgia. Principal and interest being paid in fulL

1932— St. Louis-San Francisco. Principal and interest being paid in full.

1932— Norfolk Southern. Principal and interest being paid in full.

1932— Wisconsin Central. Principal and interest being paid in full.

1933— Missouri Pacific. Principal and interest being paid in full.

1933— New Orleans Texas & Mexico. Princijjal and interest being paid in
full.

1933— International-Great Northern. Principal and interest being paid in
full.

1933— Akron, Canton & Youngstown. Principal and interest being paid in
full.

1933— Chicago & Eastern Illinois. Principal and interest being paid in full.

1933— Chicago, Rock Island Pacific. All outstanding Equipment Trust
Certificates prior to July 1, 1937, exchanged for 3K% Sinking
Fund Trustee’s Certificates due July 1, 1947. The Sinking Fund
is calculated to retire all the Certificates by maturity. Equipment
Trust 3 X A% Certificates, Series R issued by Trustees, being
paid in full principal and interest.

1935— Chicago, Milwaukee, St. Paul & Pacific R.R. Principal payments
made to March 2, 1935. Under the plan now operative, principals
maturing between April 1, 1935 and December 31, 1940, will be
paid $200 each year until paid in full. All payments of principal
and interest under the plan have been paid to date. Recent
issues of Equipment Trust Certificates being regularly serviced by
Trustees.

1935— Chicago & North Western Railway. Principal and interest being paid
in full.

1935— Chicago Great Western Railroad. Principal and interest being paid in
full.

1935— Denver & Rio Grande Western R.R. Principal and interest being paid
in full.

1935— New York, New Haven & Hartford. Principal and interest being paid
in full.

1935— St. Louis Southwestern Railway. Principal and interest being paid in
full.

1935— Western Pacific Railroad. Principal and interest being paid in full.

1937— New York, Ontario & Western. Principal and interest being paid in
full.

1937— New York, Susquehanna & Western. Principal and interest being

paid in full.

1938— Erie Railroad. Principal and interest being paid in full.

1938— Rutland Railroad. Principal payments in full to May 31, 1938.

Certain holders of 1938 and 1939 maturities consented to a volun¬
tary extension to June 1, 1941. Interest paid in full to date.

742

SECURITY ANALYSIS

It should be noted that the exchange of Receivers Certificates or Trustees
Certificates in some of the aforementioned cases resulted in a reduction of
the rate of payment to holders and that the disaffirmance of the Florida
East Coast Ry. Series D lease resulted in a sale of the equipment at a price
to net the certificate holders only 43 cents on the dollar of their obligations.
The latter case occupies a unique position in the history of railway equip¬
ment trust obligations issued under the lease plan.

NOTE 18 (page 136 of text)

Considering their investment record, equipment-trust obligations sold
at unduly high yields in 1932-1933—an opinion expressed in the 1934
edition of this work. Yields obtainable from this class of security in June
1933 and at the close of 1939 are indicated in the following table.

Current basis, %

Road and series

June 1933

December

1939

Bid

Asked

Bid

Asked

Atlantic Coast Line “ E ”.!

5.50

4.50

2.00

1.50

Baltimore & Ohio R.R. “D”.

6.75

5.50

3.25

2.00

Central of Georgia Ry. “Q”.

14.00

9.00

4.50

3.75

Chesapeake & Ohio Ry. “W”.

4.50

3.75

2.10

1.60

Chicago & North Western Ry. “U”.

12.00

8.00

3.00

Chicago Great Western R.R. “A”.

Chicago, Milwaukee, St. Paul & Pacific R.R.

12.00

9.00

4.46

“L”.

14.00

9.00

4.49

Erie R.R. Co. “NN”.

8.75

7.25

2.00

Illinois Central R.R. “P”.,....

7.00

6.00

2.50

1.75

Long Island R.R. “1” .

4.75

4.00

2.50

1.50

Missouri Pacific R.R. “D”.

12.50

9.00

5.00

New York Central R.R. “4^—1929”.

New York, New Haven & Hartford R.R.

6.50

5.50

2.15

1.25

“4H—1930”.

6.50

5.50

3.10

2 50

Northern Pacific Ry. “4}^—1925”.

6.00

5.00

1.25

0.50

Pere Marquette Ry. “4}£—1930”.

12.00

9.00

2.45

1.00

Reading Company “4J^—1930”.

4.65

4.00

2.00

1.50

Southern Pacific Co. “M”.

5.50

4.75

2.25

1.60

Southern Ry. “CC”.

11.00

8.50

2.10

1.50

NOTE 19 (page 140 of text)

An Interim, Report of the Real Estate Securities Committee of the Invest¬
ment Bankers Association of America (dated May 12, 1931 and printed

APPENDIX

743

in full in Investment Banking , June 1931, at pp. 7-10) estimated the total
volume of real estate bonds outstanding at $10,000,000,000, divided into
classes as follows:

Class 1.
Class 2.

Class 3.

Class 4.

Class 6.

Total...

Loans less than 75% of present revaluation in

good standing, with good record.

Loans that have had no evidence of trouble but
are over 75% of present value of security and
appear to be able to work out without fore¬
closure or loss.

Loans generally in excess of 75% of present
value of security where foreclosure or workout
with small loss is probable (losses 10 to 25 %)..
Items which when originally made were 80 to
100% loans. Such loans are now 125 to 150%
items, with losses from 25 to 60% when fore¬
closure and sale are completed .

In this group are the gross errors of judgment.
Incompleted, ill-conceived and misplaced build¬
ings, including many leasehold and second-
mortgage bond issues. Losses in this class will
run from 60 to 100% and items should often
be entirely abandoned.

$ 2,000,000,000

2 , 000 , 000,000

2,500,000,000

3,000,000,000

500,000,000

$10,000,000,000

In its Annual Report rendered in November 1931 before the Twentieth
Annual Convention of the Investment Bankers Association of America, the
Committee revised the foregoing estimates as follows: “The exact amount
of outstanding real-estate bonds is difficult to ascertain due to the large
number of small issues of which no record has been kept. The Federal
Reserve Board at Washington estimates that there may be a present maxi¬
mum volume outstanding of $6,000,000,000. This figure is considerably
lower than the one estimated in our May report. We believe, however,
$6,000,000,000 is approximately correct. It is the liquidation of this
volume of real-estate bonds which presents one of the major problems con¬
fronting real estate.

“Due to the decline in urban real-estate values, it is estimated that
approximately 60% of the outstanding real estate-bond issues are more or
less in distress” {Proceedings of the Twelfth Annual Convention of the Invest¬
ment Bankers Association of America , 1931 , p. 130).

The character of the distress above referred to was indicated by the
chairman of the committee in his introductory remarks when submitting
the report. He said: “Now, it is estimated that about 60% of the real-
estate bonds which have been issued are more or less in distress. Some only
show slight trouble, either in temporary default or non-payment of taxes;
others are under the process of reorganization or are in foreclosure” {ibid.,
p. 128).

744

SECURITY ANALYSIS

The growth and later decline in the volume of real estate bonds actually in
default with respect to interest and/or principal payments is shown by the
following compilation 1 by Dow, Jones & Co., Inc., as of Nov. 1 in the
respective years. Only issues sold to and held by the public are included.

1928 $ 36,229,000

1929 69,755,000

1930 137,463,000

1931 327,968,000

1932 739,326,000

1933 995,017,000

1934 647,945,000

1936 408,738,000

1938 223,534,000

NOTE 20 (page 141 of text)

A harrowing example of this kind is furnished by the “Hudson Towers”
at 72d Street and West End Avenue in New York City. This 27-story
building was erected as a hotel, sanitarium, and hospital, catering to patients
and their families. It was thus a specialized type of structure. The land
actually cost $395,000, and engineers estimated that the building would cost
$1,300,000 to construct. In order to facilitate the sale of $1,650,000 of first-
mortgage bonds, the land and building combined were “appraised” at
$2,600,000, thus making the bonds “legal for trust funds” under the New
York law. This occurred in 1923. Subsequently the building passed
through various hands by sale and resale, prior to its completion, and in 1927
second-mortgage bonds amounting to $1,150,000 were sold to the public.

The project was never completed; and in August 1932 the property was
sold for $290,000 on foreclosure of the first mortgage. The outcome from
the standpoint of the nonassenting first-mortgage bondholder is indicated
by the announcement of the Irving Trust Co. in June 1933 that it was
prepared to pay $8.14 on account of each $1,000 principal amount of unde¬
posited first-mortgage bonds. Thus, less than 1 cent on the dollar was
realized on liquidation. Depositing bondholders received only $3.84 per
$1,000 bond, after deduction of protective committee expenses, etc.

NOTE 21 (page 143 of text)

Note the following comment by the Industrial Securities Committee
of the Investment Bankers Association of America in its 1928 report ( Pro¬
ceedings of the Investment Bankers Association of America t 1928, p. 91).

“Several circulars were examined in which an offering of preferred stock
was made based upon a business housed in a building on leasehold property.
The reference to the fact of a leasehold rental being a prior charge was made
in very small typo and in a most inconspicuous way. The investor glancing
at the circular could easily derive the impression that the dividend on the
preferred stock was a first charge on the earnings. Unfortunately, inves¬
tors, as a rule, do not read circulars carefully, and the average investor

1 The Wall Street Journal, Deo. 27, 1933, and Feb. 15, 1039.

APPENDIX

745

would scarcely have noticed the mention made of the leasehold charge.
In our opinion these figures should be set forth in just the same manner
in which an interest charge on bonds would be placed.”

The argument is equally valid, of co arse, in the case of a bond issue which
is preceded by leasehold rental charges.

A leading example of a leasehold issue which encountered difficulty on
account of the ground rental is presented by the Waldorf-Astoria Corp.
(New York) First Mortgage Leasehold 7s, due in 1954.

Of the Waldorf issue SI 1,000,000 were sold to the public in October 1929.
The ground rental began at $300,000 a year, but jumped to $600,000 at the
end of two years and was graduated upward thereafter to a maximum of
$800,000 per year. In addition there were certain building and sinking-
fund rentals required to be treated as operating expenses, although they were
fixed and determinable in amount. The statement in the offering circular
that the fixed charges on the First Leasehold 7s were covered over 4.5 times
(according to an estimated income account) was therefore misleading, as
the rental charges were soon to exceed the interest on the bonds and were
lumped in with the operating expenses in such a way as to conceal (heir
true character and effect. If the buyer of the First Leasehold 7s had cap¬
italized the prior charges at 6%, he would have discovered that the $11,000,-
000 issue was junior to about $23,000,000 of prior claims.

Early in 1932 it became necessary to negotiate with the landlord (a sub¬
sidiary of the New York Central R.R.) with respect to the ground-rental
payments which were in default. A plan of readjustment was completed in
1937 whereby the landlord made certain concessions with respect to the
order and amounts in which ground rentals are to be payable in the future,
and in return the bondholders assented to a modification of the indenture
whereby their holdings were transformed into common stock and income
bonds carrying contingent charges. The bonds in this case declined to a
low price of 3J4 in 1932.

A very similar situation developed with respect to the Hotel Pierre issue.
The original bonds sold in this case at a low price of 1 cent on the dollar in
1932 and 1933. A reorganization in 1932 gave the holders of the old First
Leasehold 6Hs a drastically reduced principal amount of new Income
Debentures of 2 East 61st Street Corp. and a small amount of stock. In
April 1939 the enterprise again encountered difficulties with its rental
obligations and filed a voluntary petition in bankruptcy.

Tower Building Company (Chicago) First Leasehold 6J^s were offered
to the public in 1926 at par. The amount was $1,900,000. The leasehold
called for annual payment of a ground rent starting at $190,000 (and
increasing thereafter). These heavy leasehold payments were subsequently
defaulted; the lease was forfeited in 1931, and the bonds lost all value.

A similar disastrous fate befell the holders of 170 Broadway Corporation
(New York) First Leasehold 6>£s, due 1949.

NOTE 22 (page 149 of text)

The student will find it interesting to compare our suggested minimum
quantitative standards for bond selection with the Bond Quality Yardsticks
{Text continues on p. 749.)

Table I. —Bond Quality Ratios 1

Intended as helpful guides, not as inflexible standards nor as exclusive tests

746

SECURITY ANALYSIS

Asset protection (A)

Curr.

curr.

liaba. (C).
Better
than

400%

400

350

400

300

350

400

350

300

200

Working
capital
to fixed
debt (C).
Better
than

150%

250

150

125

100

150

200

150

100

150

100

200

Net

property
to gross
revs. (B).
Less than

100%

100

125

100

300

133

Fixed
debt to
net prop¬
erty (C).
Less than

35%

66H

Earnings protection(B)

Operating
ratio.®
Less than

84%

Net

income

to gross

revs.

Better

than

CO WffliOiOON 00 CM CO ^ CO

Income
avail, for
F. C. to
par value
of funded
debt.
Better
than

CM CM CM<N<MN<N<N CM CM CM CM CM

*2 *2

Bef. depr.,
depl.,
etc.®
Better
than

a s s x

O 00 OJ 05 CO Oi N O O v4 to *m «-•

H H H H H H

Times fixe

earn

Net.®

Better

than

CO to <oco»o<o«o<o <o<o<o O CO

Heavy Manufacturing Lines:

Steel.

Machinery.

Miscellaneous Manufacturing Lines:

Auto accessories.. .

Building supplies. .

Chemicals. .

Household products. .

Office equipment. ... .

Paper (non-newsprint). .

Extractive Industries:

Coal. .

Non-ferrous metal producers .

on. .

Food Products Companies:

Baking and dairy ... .

Miscellaneous food products .

Special Inventory Situations:

Auto tires*. .

748

SECURITY ANALYSIS

Table II.— Other Ratios por Particular Groups 1
Auto Tires, Meat Packing, Non-Ferrous Metal Fabricators
Net working capital excluding inventories to fixed debt—100% or more.

Department Stores

Inventory turnover—eight times a year or more.

Grocery Chains

Inventory turnover—12 times a year or more. Current assets excluding
inventories to current liabilities—100% or more. (This ratio is sug¬
gested for grocery chains instead of the ratio of cash and equivalent to
current liabilities used for all other industrial groups.)

Printing and Publishing

Fixed debt to net property plus good-will—50% or less (a). Index of circu¬
lation—trend (1929 — 100) should be as favorable as that of the national
average (b).

[(a) In using the item of good-will, press membership, circulation, fran¬
chises, advertising patronage, etc., as a factor of asset protection for bonds,
it is essential to determine the reasonableness of the stated figures. As a
rough guide, a representative group of newspaper companies evaluate their
“good-will” on a basis of around $30,000 per 1,000 circulation, (b) Index
of national average: 1929—100; 1930—100.4; 1931—98.2; 1932—92.3;
1933—89.1; 1934—93.0; 1935—96.8; 1930—102.0; 1937—104.8; ami
1938—100.3.]

Public Utilities

Depreciation and maintenance to operating revenues—15% for steam-
electric operating companies, 13% for hydro-electric operating com¬
panies, 12% for water companies, 25% for telephone companies. Net
operating income to net property—around 7% for all groups. Net
property to operating revenues, and operating expenses to operating
revenues—in the case of hydro-electric operating companies it is impor¬
tant that these ratios should be considered together but no standards can
be set because each situation must be appraised in the light of its own
territorial problems. Operating revenues per telephone station—$50
or more.

Railroads

Coverage of fixed charges from railway operations, average for last six
years—two times or more. Net working capital (including government
obligations with current assets and accrued taxes with current liabilities)
to fixed charges—200% or more. Maintenance of way and structure
plus maintenance of equipment (including depreciation) to gross revenues
—25% or more during past several years. Transportation expense to
gross revenues—steady or declining trend. Gross ton miles per freight
train hour—steadily upward trend. Fixed debt to market value of total
capitalization (taking bonds at par, preferred stock at the lower of par or
market, and common stock at market; year-end prices)—not over 50%.
(See text.)

1 Tables I and II are reproduced from the Deoember 4, 1939 issue of Barron's , The
Natii. nal FirMneial Weekly.

APPENDIX

740

prepared in 1939 jointly by Standard Statistics Company and the Bond
Portfolio Committee of the New York State Bankers Association. Their
proposed ratios for various groupings (except municipals) are summarized in
the appended Tables I and II, reproduced by permission from an article
entitled How to Test Your Bonds,” by E. Sherman Adams, which appeared
in the Dec. 4, 1939, issue of Barron's.

An adequate critique of these ratios would re quire too much space. It is
obvious that we consider nearly all of them either unnecessary or exces¬
sively severe, since otherwise we should have revised our own suggestions
accordingly. It should be pointed out that the yardsticks presented in
these tables “are not offered as a standard below which banks never should
go” but seem rather to represent something between “an additional working
tool” and a counsel of perfection. In our view the multiplicity of the
standards proposed detracts greatly from the practical utility of these
yardsticks. If all these tests must be met, the field of eligible bond invest¬
ment is narrowed almost intolerably. If some may be waived, the investor
is left pretty much at sea as to whirh are most important and how much
latitude he may safely allow himself.

The actual application of these yardsticks to typical bond portfolios of
savings banks or insurance companies would constitute a useful exercise in
security analysis and would also shed some light on the practical implica¬
tions of the tests suggested. Standard Corporation Records now compiles
these ratios on leading companies.

NOTE 23 (page 163 of text)

Ratios of railroad maintenance expenditures to gross operating revenues
for Class I railroads, based on the five-year period 1926-1930, inclusive, and
for 1937, are as follows by geographical divisions: 1

Region

1926-1930

1937

Main¬
tenance
of way,
%

Main¬
tenance
of equip¬
ment, %

Total,

Main¬
tenance
of w'ay,

Main¬
tenance
of equip¬
ment, %

Total,

Entire United States.

13.7

19.5

33.2

11.9

19.9

31.8

New England

15.3

17.8

33.1

13.7

17.6

31.3

Great Lakes

12 5

20.9

33.4

10.7

20.9

31.6

Central Eastern

12.5

20.7

33.2

10.4

21.0

31.4

Pocahontas.

13.4

20.0

33 4

10.2

18.3

30.5

Southern.

14.5

20.0

34.5

11 6

21.0

31.7

Northwestern.

14.5

18.3

32.8

13.8

19.0

32.8

Central Western.. ..

14.0

18.1

32.1

13.1

19.5

32.6

Southwestern.

15.9

18.0

33.8

14.0

18.3

32.3

1 Statistics of Railways in the United States , Interstate Commerce Commission, Washing¬
ton.

750

SECURITY ANALYSIS

The variations as between the different regions, as indicated above, are
distinctly smaller than they were prior to 1920. The maintenance expendi¬
tures of numerous roads fell conspicuously below the above standards during
1931 and 1932. For example, the Illinois Central ratios for 1932 were as
follows: maintenance of way, 8.36%; maintenance of equipment, 19.48%.

Sharp differences as between roads in the same geographical district also
developed, as is indicated by the following:

Year and road

Maintenance
of way, %
of gross

Maintenance
of equipment,
% of gross

Total, %
of gross

1926-1930 average for South-

western region.

15.85

17.97

33.82

Atchison:

1929

15.79

18.13

33.92

1932

11.52

23.69

35.21

St. Louis—Southwestern:

1929

19.97

16.26

36.24

1932

14.65

16.87

31.52

Southern Pacific:

1929

12.63

17.46

30.09

1932

11.86

18.57

30.43

The following study contrasts the trend of maintenance for various groups
of roads classified in accordance with their financial situation:

Item

Total maintenance ratio, %

1928

1934

1938

17 roads paying dividends in 1938.

34.5

32.2

23 solvent roads not paying dividends in 1938

32.2

30.0

21 roads insolvent in 1938.

32.6

32.3

33.0

All Class I roads.

32.8

30.7

This comparison shows, first, that dividend-paying roads tend to be more
liberal with maintenance than nondividend payers struggling to remain
solvent and, second, that roads falling into trusteeship tend to increase
their maintenance ratios even while the others are cutting down.

APPENDIX

751

NOTE 24 (page 164 of text)

The Chesapeake & Ohio Ry. Co. between the years 1921-1929 furnishes
an example of unusually heavy maintenance expenditures. This is reflected
in the following figures, which may be compared with the standard main¬
tenance ratios for the Pocahontas region given m the preceding note.

Year

Ratio of mainte¬
nance of way to
gross, %

Ratio of mainte¬
nance of equip¬
ment to gross, %

Total, %

1921

14.51

23 87

38.38

1922

12.70

27 01

39.71

1923

12.60

28.10

40.70

1924

14 40,

27.90

42 30

1925

15 20

25 30

40 05

1926

14.23

22 89

37.12

1927

14 37

22.38

36.75

1928

13.47

22 29

35 76

1929

14 39

22 36

36 75

1930

13 55

19.55

33 10

1931

12 88

18 99

31 87

The existence in the past of large current earnings of subsidiaries not paid
over to the parent company is illustrated by the following figures with
reference to Louisville & Nashville R.R. Co., 51% of whose common shares
are owned by Atlantic Coast Line R.R. Co.

Year

Earned per
share

Paid per
share

Balance after

common

dividends

Atlantic Coast
Line's equity in
L. & N.'s
undistributed
earnings

1922

$14.72

1 . .

$ 5,558,019

$2,834,590

1923

11.54

7,648,935

3,900,957

1924

12.08

6.00

7,112,794

3,627,525

1925

15 98

6.00

11,680,711

5,957,163

1926

16.60

7.00

11,232,111

5,728,377

1927

14 29

7.00

8,536,241

4,353,483

1928

12.24

7.00

6,133,220

3,127,942

1929

11.73

7.00

5,536,543

2,823,636

A similar though less striking picture is presented by the Chicago, Burling¬
ton & Quincy, which during the years 1922 to 1929, inclusive, earned sub¬
stantially more than it paid out in dividends. This was especially true in
the years 1924, 1928, and 1929, although the situation was reversed and
dividends in excess of earnings were paid in 1930, 1931, and 1932. The

752

SECURITY ANALYSIS

Great Northern Ry. Co. and the Northern Pacific Ry. Co. each owns about
48% of the Burlington common.

NOTE 25 (page 171 of text)

For examples of enterprises wholly or partially industrial in character but
masquerading under the “public utility” title see: United Public Service
Co., organized in 1927 and engaged in the electric light and power, natural
and artificial gas, ice plant and cold storage businesses; Southern Ice &
Utilities Co., organized in 1916 and engaged in the ice, ice cream, creamery,
and cold storage warehouse businesses; The Utilities Service Co., organized
in 1928 to acquire and operate 20 telephone companies in small towns and
four ice companies in large towns or cities; Central Atlantic States Service
Corp., organized in 1928 and engaged in the ice, coal, and cold storage
businesses; Westchester Service Corp., organized in 1928 and engaged in
the coal, ice, fuel oil, and building-supply businesses; National Service Cos.,
organized in 1928 as a holding company for enterprises of the Westchester
Service Corp. type, engaged in the ice, fuel, and allied industries. Examina¬
tion will reveal that these companies had capital structures of the public-
utility type despite the fact that their operations were largely or wholly
industrial in character.

Some of these companies are still in existence in substantially their
original form, but most of them have encountered financial difficulty and
been reorganized. United Public Service Co. was reorganized in 1934 as
United Public Service Corp. Southern Ice & Utilities Co. changed its name
in 1938 to Southern Ice Co. Utilities Service Co. entered receivership in
1930 and was reorganized in 1933 under a plan whereby the telephone
business was segregated from the industrial divisions. Central Atlantic
States Service Corp. was reorganized in 1934, and its properties taken over
by Cassco Corp. Westchester Service Corp. was reorganized in 1936 under
Section 77B of the Bankruptcy Act. National Service Cos. has preserved
its original identity.

NOTE 26 (page 172 of text)

At various times the Investment Bankers Association of America has
commented through its several committees upon the impropriety of bond
circulars which either omit reference to depreciation entirely, or else con¬
ceal the actual amount of the depreciation charge through including it in
some blanket item in the income account. The following quotations will
serve to illustrate:

“There are many honest differences of opinion about depreciation and
about the proper policy to provide for it, but whatever policy is adopted,
the investor is entitled to know what it is. A circular of a corporation issue
which does not mention depreciation leaves out an important factor in the
affairs of the company in which the investor is asked to place his funds**
(“Report of Special Committee on the Preparation and Use of Bond Circu-

APPENDIX

753

lars,” printed in the Proceedings of the Investment Bankers Association of
America, 1925, p. 274).

“The attention of our membership is particularly directed to the treating
of the subject of depreciation. Some few circulars omit the balance sheet
entirely, but in most instances this occurs in circulars A\here it is not par¬
ticularly vital. However, the practice is quiti* common to show earnings
before depreciation and taxes and then say nothing about the amount of
depreciation taken. Inasmuch as it is our endeavor to present to the
investor as complete a picture as is possible in an ordinary circular, it would
seem that unless the earnings before depreciation are given, the amount of
depreciation taken, and amount remaining foi bond interest and taxes,
leaving the balance to go to surplus, the investor has not all of the facts in
the case. If the investor understands a balance sheet and is at all familiar
with manufacturing, the manner in which depreciation is taken and its
amount will tell him quite a story as to the management of the concern in
question. Some circulars show earnings after depreciation and taxes but
no earnings before such deductions, it is the opinion of both the Industrial
Securities and Business Conduct Committee Chairman that the ideal picture
to the investor would be presented if the circular showed earnings before
depreciation, the amount of depreciation and the earnings after depreciation,
as separate items” (Interim Report of the Business Conduct Committee of the
Investment Bankers Association of America Bulletin , March 1927, p. 3).

NOTE 27 (page 179 of text)

EXAMPLE OF TREATMENT OF MINORITY INTEREST IN
COMPUTING INTEREST COVERAGE FOR PUBLIC-UTILITY
HOLDING-COMPANY BONDS

The report of the United Light & Railways Co. (Del.) for 1938 included
the results of American Light & Traction Co. of which it owned 54.69%
of the common stock. The earnings applicable to the 45% minority were
about SI,851,000. This minority interest may be treated in three ways, viz.:

Method A (which is the customary method). The minority interest is
deducted after the parent company’s interest charges. Under this method
the minority item does not affect the bond-interest coverage in any way.

Method B (which is accurate, but a little complicated). Subsidiary earn¬
ings and charges are included only to the extent of the parent company’s
ownership. In other words, both the earnings and the fixed charges are
reduced by the percentage applicable to the minority holdings of common
stock.

Method C (which is recommended). The minority interest is deducted
from net earnings (in the same way as an expense item) before figuring the
interest coverage. This will result in a smaller interest coverage than under
Method B, but the understatement will be moderate.

The three methods applied to United Light & Railways Co. report for
1938 will give the following results:

764

SECURITY ANALYSIS

Item

Method A
(custom¬
ary)

Method B
(accurate)

Method C
(conserva¬
tive)

Gross operating revenues .

Net earnings.

Minority interest.

Balance for fixed charges.

Fixed charges 1 .

Minority interest.

Balance for parent company stocks
Number of times fixed charges
earned.

1 Subsidiary interest and preferred dividends and parent-company interest.

* Excluding minority interest (45.31 %) in American Light & Traction figures.

Note that the only additional calculation needed to apply Method B is to
find the amount of subsidiary fixed charges applicable to the minority
interest. The adjusted fixed charges divided into the balance for parent-
company shares will give the coverage less 1. Note also that although
Method C always gives a smaller result than the other two, Method B will
give a higher or lower coverage than Method A depending on whether the
subsidiary earned its charges with a smaller or larger margin than the com¬
bined system.

NOTE 28 (page 198 of text)

Calculation of the margin of safety protecting preferred dividends has
received relatively scant attention at the hands of most writers of text¬
books on investment. In some cases this is due to the exclusion of pre¬
ferred stocks from the category of investment (e.g., the writings of Lawrence
Chamberlain), but in most instances no such explanation can be offered.
The exceedingly large volume of preferred stock outstanding in recent
decades suggests that some discriminating point of view and technique
must have been developed for choosing between issues of this type, and it
is surprising that more attention has not been given to the matter by those
who write books on the “science” of security selection.

In most instances in which the subject receives attention the prior-deduc¬
tions method of calculation is either explicitly recommended or implicit
in the discussion. For example, Carl Kraft and Louis P. Starkweather in
their Analysis of Industrial Securities , New York, 1930, use this misleading
method of calculation in their rather extensive illustrative analysis of Jones
Bros. Tea Co. without examining the resultant ratios critically. See p. 127,
ratio 20-(b), and pp. 130-132, 162, especially the 1926 and 1927 exhibits.

J. E. Kirshman in his revised Principles of Investment , New York, 1933,
refers to the coverage on Federal Water Service Corp. Preferred as having
been earned “several times over within the past few years,” which is a

APPENDIX

755

correct statement only in case the prior-deductions method of calculation
is used. The combined fixed charges and preferred dividends were never
covered more than 1.37 times during the years 1928-1932, inclusive (see
pp. 156-156, 437). Likewise, D. F. # Jordan repeatedly states the desired
margin of safety for preferred stocks in terms of the number of times the
preferred dividends alone are earned. See his Investments , 3d rev. ed., pp.
157, 160, 162, 167, 185, 192, New York, 1936. Curiously enough, he sees
the fallacy of this method in the case of preferred stocks of public-utility
holding companies and recommends the total deductions (over-all) method
of calculation (see p. 169).

Floyd F. Burtchett in his Investments and Investment Policy , New York,
1938, also embraces the prior-deductions idea (see p. 263, 287, and 325).

Badger and Guthmann, Herschel and Prime, on the other hand, forcefully
call attention to the fallacy of the prior-deductions method of calculating
coverage for preferred dividends and recommend the total-deductions cal¬
culation as standard procedure. See R. E. Badger and H. C. Guthmann,
Investment Principles and Practices , pp. 348-350, 465-467, New York, 1936;
A. H. Herschel, The Selection and Care of Sound Investments , pp. 217-222,
New York, 1925; John H. Prime, Analysis of Industrial Securities , p. 292,
New York, 1935.

NOTE 29 (page 214 of text)

See Appendix Note 27 in the 1934 edition of this work.

NOTE 30 (page 218 of text)

The statements in the text may be verified by a detailed examination of
the price records from which the following have been drawn as illustrations.
On Oct. 31, 1929, the Kansas City Terminal 4s, due 1960, sold at 86 % to
yield 4.9%, whereas, on the same day the General 4s of the Chicago, Rock
Island & Pacific Ry., due in 1988, sold at 90 to yield 4.5%. Four years
later, on Nov. 22, 1933, the Kansas City Terminal bonds sold at 86 %,
although the Rock Island General 4s had declined to 42, a price yielding
about 10%. On Dec. 8, 1927, the Terminal bonds sold at 93% and the

Issue

Price

range

1929-1939

Price

close of
1939

Yield at
close of
1939

Kansas City Terminal 4s, due 1960.

109%-78

107%

3 45%

Chicago, Rock Island & Pacif. Ry. Gen. 4s,
due 1988.

96 -10

13%

Default

Chicago, Milwaukee & St. Paul Ry. Gen 4s,
due 1989.

87%-19%

24%

Default

Missouri-Kan.-Texas R.R. Prior Lien 4s,
due 1962.

94%-ll%

14%

27.3%*

♦ Current yield, obvioualy subject to doubt concerning continuance.

756

SECURITY ANALYSIS

Chicago, Milwaukee & St. Paul Ry. General 4s, due 1989, sold at 93 to yield
somewhat less than the former. On Feb. 24, 1933, the Terminal bonds
were selling at 90, to yield about 4.65%, whereas the St. Paul General 4s
had declined to a price of 38 and a yield of around 11%. Between Nov. 7,
1927 and June 15, 1932 the Terminal 4s declined from 93 to 82% (yields
of 4.4% and 5.18%, respectively) while Missouri-Kansas-Texas R.R.
Prior Lien 4s, due 1962, declined from 93 to 31% (yields of 4.39% and over
15%, respectively).

Some features of the subsequent record of these issues are given in the
table on page 755.

NOTE 31 (page 227 of text)

The New York & Harlem R.R. situation presents some interesting aspects
of leases and guarantees.

1. The major part of the property is leased to the N.Y. Central for 401
years at a rental equivalent to bond interest and $5 dividends on the pre¬
ferred and common stock. The bond interest and principal are both
specifically guaranteed by the N.Y. Central, but there is no specific guaranty
of dividends. However, dividends have been paid regularly under the
lease since 1873.

2. The street railway properties were leased separately to N.Y. Rys. Co.
for a rental equivalent to an additional $2 per share on both classes of stock.
When N.Y. Rys. Co. became bankrupt, the lease was terminated and the
traction lines taken back and operated by the N.Y. & Harlem. In 1932 a
new lease of these properties for 999 years was negotiated with N.Y. Rys.
Corp. (successor to the former lessee). The only consideration was a lump
payment of $450,000, so that this transaction appears virtually identical
with a sale of the street railway lines for the sum mentioned.

3. Some N.Y. & Harlem stockholders endeavored to obtain large addi¬
tional payments from the N.Y. Central on the ground that the valuable
“air rights” (or rights to build over the-Harlem's right-of-way) were not
covered by the lease and had to be paid for separately. The speculative
glamor of this suit raised the price of the shares to as high as 505 in 1928,
representing less than a 1% dividend return. The suit was dismissed in
1932, by which time the price had fallen to 82%. (Price at the end of
1939 was 110.)

The Mobile & Ohio situation has some similar features of interest, viz.:

1. In 1901, Southern Ry. Co. issued “Mobile <fc Ohio Stock Trust Certifi¬
cates” in exchange for nearly all the Mobile & Ohio capital stock. It
agreed to pay 4% on these certificates in perpetuity.

2. Mobile & Ohio became prosperous and from 1908 to 1930 paid the
Southern Ry. 140% in dividends. The Interstate Commerce Commission
and the State of Alabama endeavored to compel the Southern to give up
control of the Mobile on the ground that it violated antitrust laws. At the
same time holders of Stock Trust Certificates started action looking either
to the return of the deposited stock or to obtaining larger dividends on their
certificates. The price of these advanced to 159% in 1928, in anticipation
of the legal moves.

APPENDIX

757

3. The collapse of earnings after 1929 forced Mobile & Ohio into receiver¬
ship in 1932. Interest due Sept. 1 on its bonds was defaulted, but holders
of the stock trust certificates have nonetheless regularly received the 4%
guaranteed by Southern By. In 1932 the price of the certificates had fallen
as low as 3J^, but this reflected mistrust of Southern's financial capacity
rather than any question regarding the legalit> of the obligation to pay the
4% dividend. Mobile & Ohio was merged with Gulf, Mobile, Northern R.R.
in 1940, but this development did not affect the status of the guaranteed
stock-trust certificates.

NOTE 32 (page 245 of text)

INDUSTRIAL OFFICE BUILDING COMPANY REORGANIZATION

The history of this enterprise illustrates in striking fashion the difference
between the theoretical rights and the actual experience of a first-mortgage
bondholder. In 1926 the company erected an office building in Newark,
N.J. The cost of land and building was apparently about $3,800,000, but
the land value was marked up from $300,000 to $2,000,000 through the
familiar process of “appraisal.” The cost of the building was defrayed
through sale of the following securities:

6 % first-mortgage bonds.$3,150,000

7 % unsecured notes. 450,000

Preferred stock. 450,000

Common stock. 100,000

(The mark-up of the real estate gave the common stock a “book value" of
about $1,800,000.)

Following a period of poor earnings, interest was defaulted on June 1,
1932, and a receiver was appointed. Shortly thereafter a reorganization
plan was drawn up, providing as follows:

1. The first-mortgage 6% bonds due 1947 were to be exchanged for first-
mortgage 5% income bonds, also due 1947.

2. The 7% unsecured notes due 1937 were to be exchanged for 7%
unsecured income notes, due 1948.

3. The 8% preferred stock was to be exchanged for new 8% preferred.

4. The common stock was to be exchanged for new common.

5. All these exchanges were to be made par for par or share for share.

The plan was carried out by the purchase of the property at foreclosure

sale for $100,000 by the Reorganization Committee. First-mortgage bond¬
holders who did not accept the new securities received in cash only $56.43
per $1,000 bond.

In this readjustment the bondholders gave up their fixed claim to interest,
receiving no compensation of any kind therefor, while the stockholders gave
up nothing at all. (Dividends arc to be postponed until after two-thirds of
the bonds have been retired, but such retirements inure to the benefit of the
stockholders and this provision does not really represent a sacrifice on their
part.) This was an extraordinarily one-sided composition or “compromise”
—the more so since the bondholders were clearly entitled to take direct

758

SECURITY ANALYSIS

possession of the property. The Reorganization Committee defended their
generosity to the stockholders on the ground that it was desirable to retain
the services (at a salary) of the largest stockholder as manager of the prop¬
erty. In effect the real owners of the building took a preferred-stock issue
(i.e., income bonds) for their capital and gave up all the junior equity to the
management. This seems a staggering price to pay for the supervision of an
office building.

It may be objected that our criticism is somewhat far-fetched, since the
building was unlikely to return more than the interest on the income bonds
in any case, so that the equity retained in full by the stockholders was
scarcely worth arguing about. But it is highly fallacious to measure the
potential earnings by the results shown in an unparalleled depression. View¬
ing the proposition over the long-term future, there were several different
kinds of possibilities which might make the stock equity valuable. Among
them were the following:

1. The return of prosperity and even of a new real estate boom.

2. Substantial inflation of the currency, which would reduce the burden
of the bonded debt.

3. Some special favorable development affecting the neighborhood or the
building. It happened that immediately after the Reorganization Plan
was consummated, the New York Stock Exchange made every arrangement
to transfer its business to Newark, and this very office building was spoken
of as the home of the Curb Exchange. Had this actually come about, a
large profit would have been realized entirely by the old stockholders of
this formerly bankrupt enterprise. This profit should properly have
belonged to the bondholders, because they took all the risk of future loss
(as shown by the decline of the market price of the issue to 4 in February
1933).

Attention should be called to the fact that this property, valued at
$5,500,000, was sold at foreclosure for $100,000, netting the undepositing
bondholders about 5 cents on the dollar. (The issue had been floated at
100 in 1927.) That this was a grossly inadequate price is clear from tho
fact that net earnings after taxes for the first half of 1932 had been $67,000.
In the writers’ view, the transfer of property at a negligible price in pur¬
suance of a reorganization scheme of this sort is more inequitable than the
“freezing out” of stockholders or other owners in the ordinary bankruptcy
proceeding. The right of the creditors to levy on the assets often works
great hardship, but it can scarcely be called unfair in the light of the specific
terms of the loan agreement and the original possibilities of profit to the
stockholder from the use of the borrowed funds. But in the Industrial
Office Building example, the judicial process was availed of to deprive the
individual bondholder of the remedy which he had been assured he would
have in the event of default— viz., either the taking over of the property on
his behalf, or the distribution to him of his share of the cash value of the
property realized in a bona fide sale.

A later pronouncement of the United States Supreme Court concerning
the fairness of reorganization plans is definitely opposed to this type of
adjustment of creditors’ and stockholders’ interests. See Case vs. Los

APPENDIX

759

Angeles Lumber Products Company , Ltd., 308 U.S. 106 (decided Nov. 6,
1939). The court ruled that a plan of reorganization under Section 77B
was not “fair and equitable” where, with the corporation involved insolvent,
the full value of the property available was not first applied to claims of
bondholders before stockholders were allowed to participate.

NOTE 33 (page 246 of text)

FINANCIAL INVESTING COMPANY 5s DUE 1932 AND 1940

An example taken from the investment-trust field will show how the
inclination of the trustee to avoid positive action on its own initiative oper¬
ates to deprive the bondholder of the safeguards which he is apparently
justified in counting on when he makes his commitment.

Financial Investing Co. of New York sold two 5% collateral-trust issues,
due respectively in 1932 and 1940. These bonds were secured by deposit
with the trustee of listed securities, diversified in accordance with stringent
requirements. The company covenanted to maintain such collateral at a
value of at least 120% of the outstanding bonds. The trustee was empow¬
ered: (1) to give notice to the corporation in the event the required margin
was impaired; (2) to declare the principal due if the deficiency was not
remedied within 30 days; and (3) to sell the collateral in such event and apply
the proceeds to payment of principal and interest.

These covenants appeared to give the bondholders practically the same
protection as is enjoyed by a bank making a collateral loan on marketable
securities. If the stipulated margin became impaired and was not made
good, the collateral could be sold out to satisfy the loan. The only important
difference appeared to be the allowance in the bond indenture of a 30-day
period to restore the margin to the required percentage.

But the actual history of the Financial Investing issues was strikingly
at variance with that of the typical collateral loan made by banks during
the same period. In October 1931 the margin fell below 20% and the
trustee advised the corporation of this “event of default.” The margin
was not made good within the thirty days, but the collateral was not sold.
In August 1932 the bid price for the bonds fell as low as 20. In October
1932 the principal of one issue matured and was not paid. This event
compelled action; the collateral securing both issues was sold out; and in
January 1933, 15 months after the “margin call,” the bondholders finally
received about 65 cents on the dollar.

We see here a wide discrepancy between the apparently effectual safe¬
guards accorded the bondholders in their indenture and the highly unsatis¬
factory results that they actually experienced— viz., a substantial loss, a
long delay and a particularly harrowing shrinkage in market value during
the interim. What is the explanation? Was it inertia or carelessness
on the part of the trustee? Superficially it might well seem so; yet in fact
the trustee gave much time and thought to this situation. But its efforts
were controlled—and vitiated—by the established principle of bond trustee¬
ship, viz., “Never do anything that anyone might possibly criticize, unless

760

SECURITY ANALYSTS

requested to do so by bondholders in the manner specified in the indenture.”
In the case of Financial Investing 5s, the trustee could be compelled to act
upon request in writing from the holders of 30 % of the bonds, accompanied
by the usual indemnities. The trustee hesitated to sell the collateral
promptly on its own initiative, because if the market recovered later, it
might be accused by the stockholders of having unwarrantably wiped them
out. It appears also that for a similar reason some of the bondholders were
opposed to the sale of the collateral after its value had fallen below the par
amount of the issue.

It is not difficult to show that these objections to carrying out the protec¬
tive provisions of the indenture were basically unsound. In fact, if they
were tenable, there would be no excuse for having these provisions in the
indenture. If we analyze this incident as a whole, we see that the unsatis¬
factory results flowed from a combination of:

1. The lack of clearly established rules of procedure to enforce the terms
of an indenture.

2. A typical body of bondholders with little financial acumen and less
initiative.

3. A basis of trusteeship under which the trustees look to these inert
and unreasoning bondholders for guidance, instead of guiding them.

NOTE 34 (pages 260 and 337 of text)

We believe that the two examples following should be preserved as a
warning to the analyst against excessive reliance upon (1) the protective
covenants in the indenture, and (2) the statistical exhibit, when selecting
industrial bonds.

I. Willys Overland Co. Ten-year First 6>£s, due September 1933.
Amount of original issue, $10,000,000.

A. Protective provisions:

1. A direct first mortgage upon all the fixed assets now owned or here¬
after acquired (except for new purchase-money liens), and secured
also by pledge of all stocks owned in the principal subsidiary com¬
panies. The subsidiaries were prohibited from creating mortgages
or funded debt unless same were pledged to secure this issue.

2. A sinking fund of 10% of the issue each year ($1,000,000 per annum)
was to retire 90% of the issue prior to maturity.

3. Net current assets must at all times equal at least 150% of the out¬
standing bonds.

4. Cash dividends were to be paid only out of earnings subsequent to
Sept. 1, 1923, and only if the current assets after deducting such
dividend are no less than 200 % of current liabilities, and net current
assess are not less than 200 % of the outstanding bonds at par.

B. Statistical exhibit, Dec. 31, 1928:

1. Interest had been earned 12 times in 1928; an average of over 11
times in 1923-1928; and at least times in each of the past six years.

2. The market value of the preferred and common stock on Dec. 31,
1928 was $110,000,000 or 22 times the bond issue of $5,000,000.

APPENDIX 761

3. The consolidated net current assets on Dec. 31, 1928, were $28,700,-
000, or more than five times the outstanding bonds.

4. The consolidated net tangible assets applicable to the bonds were
over 14 times the amount of the issue.

C. History subsequent to 1928: In the four years 1929-1932 the consoli¬
dated surplus decreased from $39,000,000 to $400,000. Of this shrinkage,
$6,000,000 represented dividends paid and the balance was due to operating
and other losses. Coincidentally, the net current assets of $28,700,000
were converted into a net excess of current liabilities amounting to $2,400,-
000, a total shrinkage of over $30,000,000.

The operations of the sinking fund reduced the bond issue to only $2,000,-
000 at the end of 1931, but the sinking-fund installment due July 1932 was
not met. In February 1933 receivers were appointed. Interest on the
bonds due March 1933 was defaulted, and the principal was also defaulted
in September 1933.

The bonds, which had sold as high as 101in 1931 and at 92 in 1932,
declined to 24 at the end of 1933.

It is to be noted that no action was taken by the trustees or by the bond¬
holders at the time of default in the sinking fund in July 1932, nor at the
time the working capital first declined below the stipulated minimum.
Prompt defensive measures then might have compelled payment of the
relatively small bond issue. A bondholders’ protective committee was
formed after the receivership. Finding reorganization plans impracticable,
it favored liquidation; but it then found legal difficulties in the way of fore¬
closing on its lien.

The company was finally reorganized in 1936, the bondholders receiving
shares in a real estate realization corporation and cither a block of con¬
vertible preferred or a larger block of common stock in the reorganized
company. Fortunately for the former bondholders these shares shortly
became worth more than par and defaulted interest on the old bonds.

II. Berkey and Gay Furniture Co. First 6s, due serially 1927-1941.
Amount of original issue $1,500,000.

A. Protective provisions:

1. Secured by a first lien on fixed property valued at some $4,400,000,
or over 290 % of the original issue. Additional bonds could be issued
up to $1,000,000 against pledge of additional property, but at a rate
not exceeding 50% of the cost thereof.

2. The net current assets were to be maintained at $2,000,000, and
current assets were required to equal twice current liabilities.

3. The serial maturity was equivalent to a sinking fund averaging
$70,000 annually, which would retire two-thirds of the issue prior
to maturity.

B . Statistical exhibit, Dec. 31, 1927.

1. Interest had been earned over three times in 1927; an average of
about 4J^ times in 1922-1927; and not less than three times in any
year of the six-year period.

2. Net current assets were $3,698,000, or 2J£ times the $1,460,000 of
bonds outstanding.

762

SECURITY ANALYSIS

3. Total tangible assets applicable to the issue were $8,600,000 or about
$6,000 per bond.

C. History subsequent to 1927: Between Jan. 1, 1929 and July 31, 1931,
the company reported losses aggregating nearly $3,000,000. In 1930 alone
the working capital shrank from $2,900,000 to $650,000. By July 1931
an excess of current liabilities was shown. Interest on the bonds was
defaulted in November 1931. Receivers were appointed in February 1932.
The installment of the bonds due May 1932 was defaulted. A decree
directing foreclosure under the mortgage was issued in April 1933. The
bonds, which had sold at par in 1928 and as high as 65 in March 1931, were
worth only one cent on the dollar at the end of 1933.

A protective committee was formed for the bond issue following the
default in bond interest. It is difficult to say whether or not prompter action
on behalf of the bondholders would have availed anything in this disastrous
situation. But certainly they should have bestirred themselves at the end
of 1930, when the working capital covenant had been violated, and not stood
idly by until the default in interest payments nearly a year later.

The properties were sold at foreclosure in 1935, and in 1936 $522.50 per
$1,000 bond was distributed to the holders, largely from the proceeds of a
damage suit against another company.

NOTE 35 (pages 286 and 294 of text)

Evidence of the growth in financing through privileged issues and its late
decline is provided in the following figures for the total number of privileged
issues outstanding as listed in Moody’s Manuals for the years indicated.
Both bonds and stocks are included.

Year

Total number
of privileged
issues out¬
standing

Convertible

Participating

With warrants

1925

434

(Not given)

1926

613

503

(Not given)

110

1927

1,129

537

410

182

1931

2,668

1,214

862

592

1935

1,705

860

630

215

1939

1,629

912

536

181

Statistical Series Releases Nos. 208, 243, 295 and 339 of the S.E.C. show the
characteristics of new issues sold for cash under the Securities Act of 1933,
during the period from Apr. 1, 1937 through Sept. 30, 1939. The following
data summarized from these releases indicate the trend of recent financing
through privileged senior issues

APPENDIX

763

Item

Num¬
ber of
issues

% of
total

Gross pro¬
ceeds to
issuer (000
omitted)

% of
total

Total senior issues sold. ...

439

100.00

$3,359,177

100.00

Privileged issues sold.

191

43.51

658,020

19.60

Total preferred stocks.

214

100.00

$ 470,423

100 00

Total privileged issues.

139

65.00

247,259

52 50

Convertible.

41.60

210,243

44.70

Participating.

18.70

23,637

5.00

With warrants.

4.70

_ _

13,379

2.80

Total long-term secured bonds.

135

100.00

$1,570,082

100.00

Total privileged long-term unsecured
bonds.

14.81

46,824

2.98

Convertible. . . ...

8.89

41,822

2.66

Participating..

With warrants...

5.92

$ 5,002

0.32

Total long-term unsecured bonds -

100.00

$1,312,213

100.00

Total privileged long-term unsecured
bonds.

39.24'

363,193

27.68

Convertible.

34.18

358,746

28.34

Participating.

With warrants.. ...

5.06

$ 4,477

00.34

Total short-term bonds.

100.00

$ 6,459

100.00

Total privileged short-term bonds-

9.09

744

11.50

Convertible.

9.09

744

11.50

NOTE 36 (page 308 of text)

The application of the antidilution formula to the somewhat complicated
case of Chesapeake Corp. Convertible Collateral 5s, due 1947, is based on
the following state of facts. The bonds, issued in May 1927, were secured
by the pledge of Chesapeake & Ohio Ry. Co. common stock, into which they
were made convertible after May 15, 1932. The indenture contained the
customary antidilution provisions and stated that for the purpose of com¬
puting new conversion prices 1,190,049 shares of Chesapeake & Ohio common
were to be deemed to be outstanding as of the date of issuance of the bonds.
Subsequently Chesapeake & Ohio issued new shares as follows:

(o) 296,222 shares at $100 per share to holders of record on Apr. 30,1929.
(b) 46,066.5 shares issued in 1930 in exchange for Hocking Valley Ry.
Co. common stock. Working back from the company’s reports it appears

764

SECURITY ANALYSIS

that the Hocking Valley stock was appraised at $7,076,710.18, or at the rate
of $153.62 for the C & 0 stock issued in exchange.

Finally, on July 31, 1930, the par value of Chesapeake & Ohio common
was reduced from $100 per share to $25 per share, and four new shares
were issued in exchange for each old share theretofore outstanding.

On the basis of these facts the computation of the conversion price in the
early part of 1933 was as follows:

Base figure Offer of 4/SO/29 Hocking Valley Offer of 6/12/SO

(1.190,049 X $220) + (296,222 X $100) + (46,066.6 X $153.62) + (382,211X $100)

, _ 1,190,049 + 296,222 + 46^066.5 ± 382,211 _^ ^

*" 4 (duo to 4 for 1 split on 7/31/30)

NOTE 37 (page 309 of text)

Consolidated Textile Corp. Three-year 7 % Convertible Debentures, due
1923, had a conversion privilege of this type. The indenture provided that
“The rate at which common stock of the company shall be delivered on any
such conversion shall be upon the basis of 22 shares of such common stock
for each $1,000 Note, and eleven shares of such common stock for each $500
Note, or, if any additional common stock of the company is at any time
issued by it for less than $46 per share, the rate of conversion shall be reduced
to the price in money or in fair value of property at or for which such com¬
mon stock is issued . . . and if any further stock is subsequently issued at
a lower price the conversion rate shall be still further reduced, and so on
from time to time, with a cash adjustment of interest and dividend accrued.”

These Debenture Notes were issued in April 1920. In November of that
year additional stock was offered to stockholders at $21 per share and the
conversion price was accordingly reduced to $21 per share from about $46
per share. The privilege never attained a substantial value, the stock not
having sold above 46% prior to November 1920 and failing to exceed 21%
subsequent to the lowering of the conversion price in November. The
issue was called at 102% in October 1921.

NOTE 38 (pages 309 and 317 of text)

The $67,000,000 of American Telephone & Telegraph Co. Convertible
4%s, due 1933, which were offered to shareholders in 1913, are an example
of this comparatively rare condition. The bonds were convertible into
common stock at $120 per share from Mar. 1, 1915 to Mar. 1, 1925. 'The
indenture provided that the stock obtainable on conversion was to be “part
of the authorized capital stock of the Telephone Company as such authorized
capital stock shall be constituted at the time of such conversion” and did not
contain the usual antidilution clauses. It is interesting to note that both
the preceding and subsequent convertible issues of American Telephone &
Telegraph Co. did contain an antidilution clause. See, for example, the
indentures securing the convertible 4s issued in 1906 and the convertible
4%s issued in 1929.

Over half of the 4%s, due 1933, were converted in 1915, the first year in
which the privilege was exercisable, and the balance was rapidly reduced
thereafter through conversion. In 1925, when the privilege expired,

APPENDIX

765

$1,899,400 remained unconverted, and these were called at par in 1931.
Meanwhile, prior to 1925, several privileged subscriptions were offered to
shareholders and this may account for the rapid conversion of this issue
unprotected against dilution through, shareholders* “ rights,” although the
higher yield on the stock under an $8 and $9 dividend rate doubtless was
a factor.

Another example which is not quite so clearly in point is that of the
Brooklyn Union Gas Co. Convertible 5Hs, due 1936. These were offered
in December 1925 with the right to convert into 20 shares of common stock
on or after Jan. 1, 1929. The indenture was somewhat ambiguously worded
to the effect that “in the event of a change in character of the stock of
the Company prior to the maturity of the bonds, so as to increase or decrease
the number of shares which the stockholders would be entitled to receive for
their stock, then the number of shares which the holders of these bonds shall
receive upon conversion shall be correspondingly increased or decreased.”
This left the matter in doubt as to whether protection against all forms of
dilution was afforded or whether protection was given against stock divi¬
dends, stock splits, and reverse split-ups only. It was perhaps for this
reason that very large arbitrage spreads existed between the bonds and the
stock prior to Jan. 1, 1929, when actual conversion could occur, although
here again the higher yield from dividends on the equivalent amount of
stock may have accounted in part for the discrepancies. Relevant data
are appended below.

Date

Price of

common

Equivalent
price for
bonds

Price of
bonds

Spread in
dollars per
$1,000 bond

3/19/26

71 H

143

129

$140

9/17/26

182

155

270

6/17/27

115

230

197

330

9/23/27

142

284

224

600

3/30/28

153

306

272

340

9/28/28

166

332

309

210

12/28/28

187^

375

NOTE 39 (page 310 of text)

Dodge Brothers, Inc., Convertible Debenture 6s, due 1940, illustrate the
increase in conversion price which occurs when shares in the issuing corpora¬
tion are exchanged for a smaller number of shares in a merger with another
corporation. The bonds, issued in 1925, were convertible into Class A stock
of Dodge Brothers, Inc., up to a maximum of $30,000,000 out of a total
issue of $75,000,000. Conversion was set at the rates fixed in the following
schedule:

First $5,000,000 converted, 1 share of A stock for $30 of bonds at par.

Second $5,000,000 converted, 1 share of A stock for $35 of bonds at par.

766

SECURITY ANALYSIS

Third $5,000,000 converted, 1 share of A stock for $40 of bonds at par.

Fourth $5,000,000 converted, 1 share of A stock for $50 of bonds at par.

Fifth $5,000,000 converted, 1 share of A stock for $60 of bonds at par.

Sixth $5,000,000 converted, 1 share of A stock for $70 of bonds at par.

The indenture provided that in case of merger or consolidation the pur¬
chaser must assume the bonds and provide for their conversion into the
same kind and amount of shares as were issuable in the merger or consolida¬
tion with respect to the number of shares of Class A stock to which the
holder of the bond was entitled from time to time upon conversion.

The first $15,000,000 of the bonds were converted into Dodge Brothers
Class A stock prior to the merger of that company with Chrysler Corp. in
July 1928, and the assumption of the remaining bonds by the latter. In
this acquisition five shares of the Class A stock into which the bonds were
convertible were exchanged for one share of Chrysler Corp. common.
Hence, in accordance with the indenture provisions, the fourth $5,000,000 of
bonds were thereafter convertible at the rate of four shares of Chrysler
common for each $1,000 bond (a conversion price of $250 per share for
Chrysler). Likewise, the fifth and sixth units were convertible into Chrysler
common at $3C0 and $350 per share, respectively. On May 1, 1935 the
entire outstanding balance of $30,150,500 of these bonds was called for
redemption.

NOTE 40 (page 322 of text)

Spanish River Pulp & Paper Mills, Ltd., First Mortgage 6s, due in 1931,
were issued in 1911 as a straight bond without profit-sharing privileges. A
default in interest payments occurred in 1915-1916, resulting in a com¬
promise between the bondholders and the company. Under this agreement
the overdue interest payments of 1915-1916 were postponed until October
1922; sinking-fund payments were temporarily suspended; and the holders
of these and certain bonds of affiliated companies were given the right to
receive during the life of their bonds a pro rata share of 10% of the amount
allocated in any year for dividends on the preferred and common stocks of
the Spanish River Co.

Year

Number of times
interest earned

Market range for
the bonds

1919

2.62

105K- 97

1920

3.03

97H- 93

1921

4.39

87 - 86Ji

1922

2.39

115 - 93H

1923

3.46

105 - 95

1924

4.37

104 - 97

1925

3.85

106M-106J4

1926

3.96

108 -105

1927

3.36

108%-108H

1928

Bonds called at 110

APPENDIX

767

As a result of this arrangement the bondholders not only received 10% of
all cash dividends paid on the Spanish River Co. Preferred and Common
until the bonds were retired in 1928, but they also received 10% of the
Preference Stock issued in July 1920 as a 42% stock dividend to liqui da te
accruals on the preferred stock.

The investment quality of these bonds subsequent to 1918 is indicated by
the figures shown above.

NOTE 41 (page 329 of text)

The technique of an intermediate hedging operation is illustrated by the
following transactions made in 1918-1919, involving the purchase of a
$1,000 Pierce Oil Corp. 6% Note, due 1920 and the sale of common stock
against it. The Pierce Oil note was convertible at any time into 50 shares
of common stock. (Accrued interest on the note is excluded.)

Date

Purchase

Range for
month

Sale

Range for
month

Oct. 1918.

1M 6% note at

99%-101 Y t

25 common at

16%-19%

100 % = SI,008

19 = $ 470

Dec. 1918.

25 common at

15 Ytr 17

16 = $ 403

Jan. 1919.

25 common at

10 -19%

19 - $ 470

May 1919.

25 common at

24%-28%

28 = $ 696

Dec. 1919.

50 common at

17 - 20%

1M note at

Called at

173^ - $ 881

100 = $1,000

100

$2,292

$2,636

Profit.

$ 344

Low price for note, October 1918 to December 1919, was 99H«

These five transactions may be analyzed as follows:

1. Purchase of note and sale of half of related stock against it, at price
not far from parity. This permitted a covering profit if the stock declined
and a profit through sale of the other half if the stock advanced.

2. A decline in the stock permitted the covering profit.

3. Recovery of the stock permitted the original position to be restored.

4. Advance of the stock permitted sale of second half at price to assure
profit on the operation.

5. Renewed decline in the stock permitted repurchase at profit of shares
sold while note was disposed of at par.

Because the near maturity of the note issue (coupled with the reasonably
strong financial condition of the company) could be counted upon fairly well
to keep its price up, it was not necessary to sell out the note at Step 2. It
could be held in the hope that the sale of the stock could be repeated.

788

SECURITY ANALYSIS

NOTE 42 (page 330 of text)

We have already indicated in Chap. XIV that 95% of all preferred stocks
listed on the New York Stock Exchange failed to maintain an investment
price level in 1932. A study by Adolph H. Graetz of large samples of bonds
for each of the years 1931-1934 indicates the following distribution of annual
low prices:

Corporate Bond Prices at Titeir Annual Lows, 1931-1934

Class (by
price range)

1931

1932

1933

1934

Num¬

ber

Cumu¬

lative

% l

Num¬

ber

Cumu¬
lative
% L !

Num¬

ber

Cumu¬

lative

% l

Num- 1
ber

Cumu¬

lative

% l

0- 9.9

245

5.69

623

13.82

683

14.78

555

12.28

10-19.9

334

13.45

562

26.29 1

507

25.75

459

22.57

20-29.9

335

21.23

419

35.59

438

35.23

370

30.63

30-39.9

380

30.06

388

44.20

418

44.28

333

38.02

40-49.9

296

36.94

364

52.28

403

53.00

331

45.40

50-59.9

319

44.35

426

61.73

381

61.24

372

53.46

60-69.9

377

53.10

384

70.25

384

69.55

340

60.86

70-79.9

461

63.81

417

79.50

405

78.31

409

70.04

80-89.9

571

77.07

406

88.51

399

86.94

435

79.79

90-99.9

835

96.47

450

98.49

467

97.04

568

92.61

100 and over

152

100.00

137

100.00

334

100.00

Total.

4,305

4,507

4,622

4,506

1 Percentage of the total whoso prices fell on or below the upper limit of the indicated
class interval.

The current situation with respect to bonds selling at speculative levels
(in 1939) is indicated by the fact that the average price of all U. S. corporate
bonds listed on the New York Stock Exchange at the end of 1939 was
74.60, a level suggesting that many issues were selling at very large dis¬
counts below par. The complete price record of all corporate bonds and
certificates of deposit therefor that were actually traded on the New York
stock Exchange during 1939 reveals that 558, or 57%, of a total of 1,100
issues sold at prices below 70 at some time during the year. A preponderant
number of the low-priced issues were those of railroads. See Commercial
and Financial Chronicle , pp. 56-64, Jan. 6, 1940.

NOTE 43 (page 337 of text)

SUBSEQUENT HISTORY OF BONDS IN THE TABLE

American Seating 6s, due 1936, were extended for ten years and sold as
high as 104 in 1939.

APPENDIX 769

Crucible Steel 5s, due 1940, rose to a price of 104J^ in 1937 and were
called for payment at 101 in September 1938.

McKesson <& Robbins 5)^s, due 1950, proved to be a profitable purchase
at 25; but after selling above par in 1935-1938 they slumped to a price of
50 in late 1938 and early 1939 on news of fraudulent conduct by the manage**
ment. Interest payment was deferred in May 1939, but by April 1940 the
bonds had recovered to a price of 101.

Marion Steam Shovel 6s, due 1947, have exhibited the poorest record of
the list. However, the bonds gradually gained to a price level of par in
1936-1937 and sold as high as 87 in 1939.

Some holders of the National Acme 6s, due 1942, extended the maturity
of their bonds in 1936 to 1946 and consented a reduction of the coupon
rate to 4H%. These bonds have consistently sold close to par since 1936.
The unextended bonds were called at 102]^ in December 1936.

NOTE 44 (page 369 of text)

Sequels to the three examples given in the text are indicated in the follow¬
ing table:

Item

Electric
Power and
Light

Bangor and
Aroostook

Chicago

Yellow

Cab

Subsequent low price ..

Ratio of low to 1929 high

1.15%

9.51%

17.14%

High price after 1933.

Ratio of subsequent high to 1929

26^ (1937)

49% (1936)

32 (1936)

high.

30.7%

54.7%

91.4%

1939 closing price .

Ratio of 1939 close to 1929 high

12%

price.

Average earnings per share,

7.9%

14.2%

23.9%

1930-1939.

Average dividends per share,

SO.05 (d)

$3.85

$1.21

1930-1939.

0.25

2.61

1.60

Earnings per share, 1939.

0.39 (d)

0.17

1.04

NOTE 46 (page 371 of text)

SWIFT & COMPANY

In 1939 the stock of this company sold at an average price of about $21
per share. Receiving $1.20 in dividends, its average yield was 5.70 %. Net
current assets available for the stock, including interest in such assets of
subsidiaries, were about equal to the market price. Total tangible assets
for the stock were just about double the market price.

The financial picture, in October 1939, may be summarized as follows:

770

SECURITY ANALYSIS

Capitalization:

Bonds. $ 36,000,000

Stock (6,920,000 sh. @ 21). 124,000,000

Total selling price of company. . $160,000,000

Net current assets 1 . 139,000,000

Net tangible assets. 286,000,000

Sales, 1939 fiscal year. 767,000,000

Net for stock, 1939 fiscal year. 10,322,000

* Excluding interest in non-consolidated subsidiaries.

Following is a condensed presentation of the company’s record since the
beginning of the century, as applied to the equivalent of the present $26
shares.

Year

Earned

per

share 1

Divi¬

dend

per

share 1

Net

tangible

asset

value

per

share 1

Market

price

per

share 1

Total

stock¬

holders'

investment

(including

voluntary

reserves)

Fiscal years:

1939.

$1.74

$1.20

$41.40

(millions)

$250

1900.

2.19

1.67

22.45

(est) 21

Average of:

Decade 1930-1939..

1.36

1.20

40.60

20 H

244

Decade 1920-1929..

1.81

2.00

38.75

28 %

233

Decade 1910-1919..

3.67

2.37

33.66

24 %

120

Decade 1900-1909..

2.42

1.52

25 60

40 years, 1900-1939...

2.32

1.78

34.65

23%

160

1 All per-share figures prior to 1918 are adjusted for a 25% dividend paid in that year.

Discussion: This enterprise is the leading factor in one of the largest indus¬
tries in the country. In fact, Swift & Co. has in some years reported a larger
dollar volume of sales than any other American corporation. During the
42 years 1898-1939 it has paid a dividend in every year except 1937 and
earned a net profit in every year but three. Its stockholders 1 equity has
grown from $15,000,000 in 1898 to $250,000,000 in 1939. Yet this com¬
pany's shares sold in 1939 (and on the average through 1930-1939) for less
than half their tangible investment, and for no more than their equity in
net current assets alone, disregarding completely the manufacturing plants,
the transportation equipment, the trade names and good-will and other
assets. What is wrong?

If we ask why Wall Street is not willing to pay so much for Swift & Co. as
is invested in the business, the answer is simple. Earnings on this invested
capital over the past decade have averaged less than 4%, and the trend of
profits in the past twenty years has been predominantly downward. But

APPENDIX

771

the real question is why these unfavorable factors are sufficient to cut the
value of Swift in half—comparing market price with tangible assets—when
all common stocks on the New York Stock Exchange have been se llin g in
the aggregate at 50% more than book value {e.g. f at the end of 1938). Col¬
lateral thereto is the question why the price of Swift & Co. must be so low
as to return an average yield of 6%, as against only 4% returned in 1930-
1939 by common stocks generally (c/. Moody’s Index covering 200 leading
issues).

The low price of Swift & Co.—in relation to the criteria of average earn¬
ings, dividends and book value—is a spectacular illustration of the dominat¬
ing influence of earnings-trend upon stock-market valuations. Clearly the
market is going farther here than merely registering a lack of enthusiasm for
the company’s prospects. Actually, it has been stating in explicit terms
that it doubts the ability of the company to earn as much in the future as
even the reduced rate of the 1930-1939 decade, that it doubts the continu¬
ance of the $1.23 dividend rate, and that it does not believe that the huge
tangible investment is of any particular value as an assurance of future
earning power.

But we, in turn, must express doubt whether the market’s appraisal of
Swift actually represents any careful endeavor to w’eigh future probabilities
or to balance the pros and cons in detail. The lack of an expanding demand
for meat is a drawback, certainly. But may it not be offset by such factors
as (1) the underlying stability and permanence of the packing industry;

(2) the tremendous prestige and financial strength of the Swift organization;

(3) the consideration that the meat industry has “ taken its bath” of Govern¬
ment regulation and that its low profit margin and small earnings on true
investment may protect it from political dangers threatening more lucrative
industries?

From this viewpoint the Swift example may be said to present a clean-cut
test of the validity of current investment attitudes. Our criticism is
directed not so much against Wall Street’s verdict—which the future may
uphold or upset—as against the foreshortening of its analysis. Suppose that
Swift were selling at 7, as it did in 1932 and 1933, the philosophy of Wall
Street would still condemn its purchase as a commitment in a “ declining
industry.” But it cannot possibly be true that all values disappear from a
concern once it has ceased to expand. Hence at some price a “bad” com¬
pany like Swift must be a good investment just as at some price a “good”
company like Parke, Davis must be a bad investment. (A comparison of
the two as of December 1939 should interest the student.) Hence, further,
the real business of Wall Street, as an appraiser and advisor on values,
should be to determine with care the relative weight of the growth factor in
the total picture—instead of seeking merely a quick and easy classification
of every company on the Judgment-day basis of either eternally blessed or
eternally damned.

On the other hand it should be pointed out that the ten-year market
record of Swift & Co. is a challenge to its management. It poses problems
to be discussed among the directors and with the stockholders. Certainly
a management as capable as that of Swift should not be satisfied unless it

772

SECURITY ANALYSIS

earns enough on the tangible investment alone to support a market value
equal thereto. If conditions will not permit this, on the average, then the
underlying factors responsible for this disappointing result must be studied
objectively, the possible remedies canvassed with thoroughness and the
matter fully reported upon to the 59,000 owners of the business.

NOTE 46 (page 379 of text)

The corporation statutes of most continental countries prescribe certain
compulsory reserves, one of the functions of which is to facilitate mainte¬
nance of regular dividends. These reserves arc accumulated from annual
profits but ordinarily do not reach large proportions. The power to declare
dividends usually resides in the stockholders assembled at the “general
meeting ,, which is an annual affair, although provision for interim dividends
is also made.

In England the Companies Act does not limit the dividend-declaring
function to the annual “general meeting” of the shareholders; but the
recommended form of by-laws (Table A of the statute) provides for this
mode of declaration and it is the general custom in framing articles of asso¬
ciation to stipulate that “the company in general meeting” or “the directors
with the sanction of a general meeting,” may declare annual dividends.
See First Schedule, Table A of the Companies Act, 1929, 19 & 20 Geo. V.,
Chap. 23. A discussion of British dividend law and policies is available
in Palmer*s Company Law , 13th ed., pp. 222-223, 628, London, 1929.

The following statements summarize more detailed information concern¬
ing dividend policies of certain foreign corporations, given on p. 669-670 of
the 1934 edition of this work, as well as the subsequent record in each case:

1. Royal Dutch Co. for the Working of Petroleum Wells in the Nether¬
lands Indies, for the period 1920-1938, inclusive:

(а) Available for ordinary stock. FI. 1,530,396,000

(б) Paid on ordinary stock. FI. 1,497,293,000

dividends. 97.84

2. Siemens & Halske A. G., for the period 1925-1938, inclusive:

(а) Net profit. Rm. 150,893,000

(б) Dividends. 124,419,000

(d) Special reserves 1 . 25,550,000

(e) Balance. 2,534,000 (d.)

1 Including 3,000,000 Rm. for welfare fund.

3. British-American Tobacco Co., Ltd., for fiscal years ending Sept. 30,
1921 to Sept. 30, 1938, inclusive:

(o) Net income available for ordinary stock... £91,934,000

(6) Dividends on ordinary stock. 87,240,000

APPENDIX

773

4. In the case of General Electric Co., Ltd., the American policy of retain¬
ing a fair proportion of the earnings has apparently been followed. The
greater part of these surplus earnings, however, were carried to “Reserve
Account.” The following figures summarize the period 1925 through Mar.
31, 1939:

(а) Net income. £10,433,000

(б) Preferred dividends. 3,468,000

(< d ) Appropriation for reserves. 1,847,000

(e) Balance to surplus. 597,000

NOTE 47 (page 410 of text)

The reader is referred to House Doc. Xo. 70, 76th Congress, 1st Session
(Washington, 1939), The Statistical Survey of Investment Trusts and Invest¬
ment Companies , especially to pp. 463-493, 833-937, for a more complete
statement concerning the results of the detailed examination by the S.E.C.
staff of the performance of large management investment companies over
the period 1927-1937. The method of analysis employed by the S.E.C.
staff was, in general, to compare fluctuations in net assets (without deduc¬
tion of funded debt) 1 of investment companies with fluctuations in the
Standard Statistics index of 90 common stocks, and with a combined security
relative constructed to afford greater comparability with investment trusts
due to the fact that the latter do not confine their commitments to common
stocks entirely.

The following generalizations of the results of this study are quoted from
pp. 904-906 of the House Document cited above:

“The analysis in this appendix indicates that large management invest¬
ment companies proper . . . typically performed like an index of common
stocks with but few companies bettering this performance. The only
important tendency to departure from the index would seem to have resulted
from the investments other than common stocks, and from the increase in the
proportion of this type of investment during years of declining stock prices
and the decrease in these investments during rising markets. There is no
evidence that many companies were able consistently to perform better than
the index year after year. The analysis indicates that the net result of the
interplay of all performance determinants was simply the performance of
leading common stocks, as represented by an index. Whether the perform¬
ance of investment companies is simply the performance of listed common
stocks selected at random cannot be answered by this analysis. The typical
performance of investment companies mignt well be better than the per¬
formance of stocks obtained through strictly random selection, although

i The effect of repurchases of the companies’ own securities at discounts below asset
values was eliminated. Adjustments were also made for distributions to shareholders by the
investment companies and by the components of representative groups or averages with
which the trusts’ performance was compared.

774

SECURITY ANALYSIS

such a result would imply that the stocks represented in the index also do
better than stocks selected at random. . . .

41 It can, then, be concluded with considerable assurance that the entire
group of management investment companies proper (as opposed to the
sample here studied) failed to perform better than an index of leading com¬
mon stocks and probably performed somewhat worse than the index over
the 1927-1935 period. . . .

u With respect to fixed and semifixed investment trusts . . . the typical
performance over the 1930-1935 period was below the performance of the
index, although by a fairly small margin. Virtually all fixed and semifixed
trusts invested their assets in common stocks, and consequently their per¬
formance was worse in years of declining stock prices and better in years of
rising prices than investment companies proper. . . . All factors considered,
it is doubtful that fixed trusts performed much worse over the period 1930-
1935 than the average management investment company proper.”

The following table analyzes the performance of the six largest invest¬
ment companies (as of Dec. 31, 1939) for the 4- and 6-year periods ending
on that date. The over-all results are compared with the Standard Statis¬
tics 420-stock index, which is the most comprehensive available. The
dividend return on this index is, somewhat arbitrarily, estimated as the same
in percentage as that on the Dow-Jones average of 30 industrial stocks.

Performance of Six Largest Investment Companies 1934-1939 and

1936-1939

Company

Asset value per share
Dec. 31

Dividend

paid

Over-all
gain in
value, %

1933

1935

1939

1934-

1939

1936-

1939

1934-

1939

1936-

1939

Atlas Corp.

$11.03

$15.25

$12.80

$ 2.90

42.4

Dividend Shares.

1.21

1.28

0.54

50.4

7.1

Incorp. Investors.

17.99

16.34

9.93

6.66

10.3

Lehman Corp.

26.84

37.10

32.72

9.72

54.4

9.8

Mass. Invest. Trust.

17.70

6.39

4.91

54.5

7.9

State St. Investment...

65.34

71.81

70.6

16.8

Standard Statistics 420

(est.)

Stock Index.

71.0

96.8

94.3

18.3

66.6

16.3

* Adjusted.

The following brief tabulation compares the holdings of cash and govern¬
ment bonds by 12 investment companies on various dates in 1937-1939 with
the Dow-Jones industrial average on those dates. It will be observed that
cash holdings move inversely with the average, suggesting that the com¬
panies tend to buy in rising markets and sell in declining markets.

APPENDIX

775

Date

Dow-Jones

industrial

average

Cash and U. S.
Bonds held by 12
investment
companies 1

Sept. 30, 1937.

154.5

$35,057,000

Mar. 31, 1938.

99.

82,796,000

Dec. 31, 1938.

154.8

27,093,000

June 30, 1939.

130.6

35,858,000

Sept. 30, 1939.

152.5

23,775,000

1 The companies are: Adams Express, Blue Ridge, Equity Corp , General American,
Incorporated Investors, Lehman Corp., Niagara Share, Quarterly Income Shares, Selected
Industries, Tri-Continental, U. S. & Foreign Secunties, U. S. & International Securities.

NOTE 48 (page 421 of text)

The difference between the standard and the “last-in, first-out ,, methods
of computing cost of goods sold can be illustrated by the following simplified
and hypothetical example:

A company starts with 10,000,000 pounds of copper, buys 10,000,000
pounds each year for three years and sells 10,000,000 pounds a year at a
2 cent advance above the market. The initial cost and market price is
10 cents; the average cost and closing price is 15 cents the first year, 5 cents
the second year and 10 cents the third year.

Standard Method

First year

Second year

Third year

Proceeds of goods

sold.

SI,700,000

S 700,000

$1,200,000

Cost of goods sold:

Opening inventory

1,000.000

1,500,000

500,000

Purchases.

1,500,000

500,000

1,000,000

2,500,000

2,000,000

1,500,000

Less closing inven¬

tory (lower of cost

or market).

1,500,000 1,000,000

500,000 1,500,000

1,000,000 500,000

Gross profit....

$ 700,000

Loss $ 800,000

$ 700,000

Last-in, First-out Method

Proceeds of goods
sold.

$1,700,000

$700,000

$1,200,000

Cost of goods sold
(same as pur¬
chases during

year).

1,500,000

500,000

1.000.000

Gross profit ...

$ 200,000

$200,000

$ 200,000

770

SECURITY ANALYSIS

Obviously the company ends up where it started in inventory and has
made a continuous profit of 2 cents per pound. Common sense would insist
that the company has made (gross) $200,000 each year. But the standard
accounting method would show a profit of $700,000 the first year, a loss of
$800,000 the second year and a profit of $700,000 the third year. In the
years prior to 1939, when no carry-over of losses was permitted, the company
would be subject to income tax on $1,400,000. Under the 1939 law, and
using the standard method, taxable income for the period would be $700,000
—the first year’s “profit”—and none thereafter.

However, by the last-in, first-out method, the profit would work out as
$200,000 each year—the sensible figure—and income tax would be payable
on this amount.

The calculations are as shown in the table at the bottom of page 775.

NOTE 49 (page 422 of text)

ILLUSTRATION OF THE NORMAL-STOCK METHOD OF
INVENTORY

The working of various inventory-reserve methods is shown in the sub¬
joined figures covering the operations of Plymouth Cordage Co. in the ten
years 1930-1939. Prior to 1932 a somewhat arbitrary policy was followed,

Plymouth Cordage Company
(000 omitted)

Date or year
ended Sept. 30:

Inventory figures

Net earnings for year

Before re¬
serve ad¬
justments

After reserve
adjustments

Before

reserve 1

After

company’8

reserve

After nor¬
mal-stock
reserve*

As made
by com¬
pany

As required
by normal-
stock
method

1929

$8,059

$7,110

$4,297

1930

4,367

$658(d)

$288

$1,463

1931

4,011

3,292

943

1932

3,150

3,102

233(d)

444

1933

3,473

3,143

3,238

486

157

294

1934

5,144

4,471

4,722

619

276

432

1935

4,030

3,358

3,503

475

370

1936

5,191

4,193

892

466

320

1937

5,315

3,291

1,195

269

1938

4,849

3,877

1,066(d)

9(d)

1939

4,635

3,457

336

130

Average 10 years

I .

$207

$184

$ 466

1 At lower of cost or market.

1 1929-1936 figures supplied us by courtesy of Plymouth Cordage Co.

APPENDIX

777

under which a substantial reserve appeared in 1929, which was absorbed
the following year, leaving no further reserve until 1933. For that year
and the next a policy was adopted of marking down the entire inventory
to the 1932 low prices. In 1935 the reserve was kept intact although not
entirely needed. Beginning with 1930 the company adopted the normal-
stock method, applying a sufficient reserve to reduce the minimum supply
required for operation to the lowest price level previously experienced.

Our table indicates how the normal-stock method would have worked out
if it had been followed through the decade, as compared with the results
actually reported. The most significant fact is that the normal-stock
technique would have reduced the earnings fluctuations greatly and also
have resulted in far higher aggregate earnings i\,r the period. The reason
for the latter point is that the results as published absorb a considerable
shrinkage of the Sept. 30, 1929, inventory, in addition to the reserve provided
on that date. These figures suggest that Plymouth Cordage would have
made an excellent exhibit during the depression years 1930-1932 if the
normal-stock method had been in effect at that time. ( Cf . our analysis on
pp. 621-622, based on the published reports.) Note also the relatively
small variation in net inventory after normal-stock reserve, as compared
with the unadjusted figures.

NOTE 50 (page 424 of text)

Between Jan. 1 , 1929, and Jan. 31, 1933, Interstate Department Stores,
Inc., acquired 30,000 shares of its common stock at an average cost of
$20.62 per share. On the latter date it wrote this stock down to $5 per
share on its books by a charge of $468,689 against earned surplus and
reserved 20,000 of the shares to compensate management in future years
under agreements with respect thereto. In the three fiscal years ended
Jan. 31, 1937, it issued 12,432 of these shares to management and charged
the income accounts with the cost of these managerial services at the rate
of $5 per share, although the stock had cost the company considerably more

Fiscal year
ending
Jan. 31

Net income
reported 1

Net income
on average
cost basis 2

Net income
on market
value basis 3

Net income
on cash com¬
pensation
basis 4

1935

$468,350

$418,991

$442,675

$453,095

1936

446,650

402,445

423,718

432,080

1937

882,002

781,378

715,997

852,438

1 After charging out the stock at $5 per share.

1 Charging income with the stock at its average original cost.

* Charging income with the stock at its market value on the dates of distribution to
management.

4 Charging inoome with the amount of cash compensation that the management had the
option of taking in lieu of the stock.

778

SECURITY ANALYSIS

and was selling in the market at prices substantially above $5 per share
at the times of issuance.

The table at the bottom of page 777, reveals the effect of these trans¬
actions on the income reported, as disclosed in the prospectus of the com¬
pany, dated May 13,1937.

NOTE 51 (page 429 of text)

Following is a condensed summary of the more important points of differ¬
ence that may arise between corporate income subject to income tax and
the net earnings reported to the stockholders. These are based on the
Revenue Act of 1939.

Differences that will in¬
crease the earnings sub¬
ject to income tax

Differences that will de¬
crease the earnings sub¬
ject to tax

I. Items in reported
income account ex¬
cluded from income
account for tax
purposes

Short-term capital loss
for current year
Insurance paid on of¬
ficers’ lives

Mark-down of securities
owned to market

85% of domestic divi¬
dends received

Interest received on gov¬
ernment, state and
municipal bonds

II. Items generally
shown in the sur¬
plus account, which
are included in the
tax return

Profit on sale of capital
assets

Income received appli¬
cable to prior years
Profit on certain sales of
capital stock

Long-term loss on sale of
capital assets

Certain development ex¬
penses to be written
off in future years
Premium and unamor¬
tized discount on bonds
retired

Loss on certain sales of
capital stock

Current year’s amortiza¬
tion of bond discount
previously charged off
in its entirety against
surplus

TIL Items not appear¬
ing in the reported
income or surplus
account for the cur¬
rent year

(Certain) net losses car¬
ried over from preced¬
ing or next preceding
year

(Certain) short-term

capital losses carried
over from the preced¬
ing year

APPENDIX

779

IV. Other differences:

A. Depreciation and other amortization may be computed by different
methods in the tax return and on the published statement.

The amount of the tax may be reduced by reason of income and
similar taxes paid outside the United States.

NOTE 62 (page 467 of text)

Following are three varying examples of the exclusion of part of the amor¬
tization allowance from the income account.

Example A: Pennsylvania-Dixie Cement Co. As of Jan. 1, 1937, this
company created a special reserve of $9,373,000 (by a charge to capital
surplus) in order to write down the value of its plant to a figure that elim¬
inates a mark-up made at the time of the company's formation in 1926.
(The capital surplus had in turn been created by arbitrarily writing down
the capital liability of the $7-dividend no-par preferred from $100 to $25.)
In 1936 the amortization charge had been $1,367,661, but in 1937 the com¬
pany charged only $585,000 therefor against income and the balance of
$744,000 against the special reserve. The result of these entries was to
show fixed charges earned with a small margin in 1937 and 1938, whereas
on the old basis there would have been a deficit before interest deduction.

In this case the lower depreciation charge may seem justified, since it
applies to original cost of plant instead of to appreciated value. It would
have been simpler had the company merely written down the plant account
and thereafter made a single amortization charge on the lower basis. Reten¬
tion of the higher plant figure on the books, subject to the special reserve,
may have been motivated by a desire to justify the original heavy senior
capitalization in bonds and preferred stock.

Example B: Symington-Gould Corp. In 1938 this company charged
$168,000 against income for depreciation and an additional $165,000 against
a “reserve for reduction of plant values.” About the same was done in
1937. The original reserve, set up at the beginning of 1937, was about
$880,000, as against a gross plant account of $7,500,000.

This arrangement differs from the Penn-Dixie Cement example because
the reserve is proportionately much smaller, being enough to cover extra
amortization charges for about five years. By this device the net plant
account was only moderately reduced on the balance sheet, whereas on the
other hand the depreciation charge against income was cut in half.

Example C: Climax Molybdenum Co. For 1938 this mining enterprise
charged only $20,000 for depletion against earnings (this being based on the
cost of the mine) and the large sum of $2,341,000 for depletion against
“discovered increment” on the balance shed

Obviously, the income-account charge for depletion is meaningless for
the investor. The charge against “discovered increment” is useful as an
indication of remaining life of the mine—about 29 years in 1938, subject to
new developments. Note that the company’s charge is calculated against
an appraised value of about 72 millions for the mine, whereas the average
price of about 47 for the stock in 1939 is equivalent to a valuation of about

780

SECURITY ANALYSIS

111 millions for the mine. Hence the analyst's charge for depletion based
on market values would be higher than that made by the company against
surplus.

It may be contended that in dealing with a 30-year life, allowance should
be made for compound interest, thus reducing substantially the annual
depletion provision. In view of the many uncertainties involved in a mining
venture, it would seem sensible to follow the simpler ‘ ‘straight-line” method,
thus setting up a certain margin of safety against future eventualities.

NOTE 63 (page 613 of text)

In the 1934 edition of this work (page 434) we suggested at this point that
in the case of Company A the analyst “would consider the reasonable value
in terms of the $4 per-share average earnings multiplied by a coefficient
which may be as high as 16. This would result in a value of about 65.”
Our present treatment marks a significant departure from the earlier view
in two respects: (1) by advancing the multiplier from 16 to 20 and (2) by
accepting in this case the most recent year’s earnings in lieu of the average,
as the measure of indicated earning power.

The advance in the multiplier follows naturally, we believe, from the
persistence of much lower bond-interest rates than had been the rule prior
to 1934. (The average yield on Standard Statistics A1 + bonds early in
1940 was 2.78% compared with 4.67% in 1933 and 4.78% in 1929. See
Appendix Note 57, page 784, for further discussion regarding the suggested
new maximum multiplier of 20.)

In permitting the use at times of the most recent year’s earnings, rather
than the average, we have definitely shifted our viewpoint in a more liberal
direction. The reason is that on further reflection it appears to us that the
current (or last) year’s earnings are more relevant to the future, and therefore
a more realistic measure of earning power, in cases where (1) they are not
aided by unusually good general business conditions, (2) there has been a
pronounced upward trend and (3) long-term prospects appear favorable.

NOTE 64 (page 616 of text)

At this point (page 437) in the 1934 edition we supplied the following
illustration:

“ Example: Let us take the situation presented by Mack Trucks, Inc.,
in 1933 when the shares were selling at an extremely low price in relation
both to their asset values and to their average earnings. At the time the
annual report was released early in March 1933 the common stock was
selling at $15 per share. The report exhibited net cash assets available for
the common stock of $12 per share and net current assets of $40 per share.
The earnings exhibit is shown in the table at the top of page 781.

“It will be observed from the above that the stock was selling in March
1933 at slightly in excess of one-third of the net current assets per share and
at little more than twice the average earnings per share.

“This company was the largest unit in an important industry, so that
there was every reason to expect that it would again be able to earn a

APPENDIX

781

Year

Available for
common

For share

Dividends paid

1932

$1,480,000(d)

'$ 2.19(d)

$1.00

1931

2,150,000(d)*

2.90(d' *

2 25

1930

2,008,000

2.67

5.50

1929

6,841,000

9.05

6.00

1928

6,915,000

7.83

6.00

1927

4,707,000

6.60

6.00

1926

7,716,000

10.81

6.00

1925

8,331,000

13.64

6.00 and 50% in stock

1924

6,083,000

11.97 f

6.00

1923

6,866,000

13.81f

5.00

Average.

4,284,000

7.13

* Before extraordinary write-down of too'a, etc., to $1.
f Adjusted for 50% stock dividend paid Dec. 31, 1925.

reasonable profit on its invested capital. But the low price of Mack Trucks
presented another anomaly. The decline in the investment status of the
railroads had been due largely to the growth of motor-truck competition
and to the pervading fear that such competition would continue to attract
traffic from the railways. On this premise the long-term outlook for heavy
truck manufacturers should have seemed unusually good. Hence to the
analyst the exceedingly subnormal price of Mack Truck shares had an
especially illogical appearance.”

Sequel and Discussion: The subsequent developments in the Mack Truck
situation may be summarized in the following table:

Year

Earned per share

Dividend paid

Price range

1933

1.42 (d)

1.00

46^-13^

1934

0.03

1.00

41>V22

1935

0.66 {d)

1.00

30»i-18M

1936

2.41

1.50

49^-27%

1937

2 15

1.25

62J4-17 %

1938

1.56 ( 1 d)

0.25

32^-16

1939

1.14

0.50 I

33^-18

The expectation of a return of adequate earnings on invested capital has
clearly failed of realization. The reasons appear to be related, first, to a
lack of sustained activity in capital goods industries generally, among
which heavy-duty truck production is to be included; and, second, to a
falling off in the position of Mack in its own field.

In view of the low level of stock prices prevailing in early 1933, it is not
surprising, however, that a purchase of Mack Truck at 15 would have proved
quite profitable. We believe that a twofold moral may be drawn from this

782

SECURITY ANALYSIS

example: (1) The analyst’s views as to a company’s future may prove erro¬
neous, either because of poor judgment or for other reasons. (2) It is part of
the analyst’s approach to guard as far as possible against the unexpected
by requiring an ample current margin of safety above the price paid for a
common stock.

NOTE 66 (page 620 of text)

SUBSEQUENT PERFORMANCE OF BREWERY STOCKS FLOATED

IN 1933-1934

A study was made of all the brewery-stock flotations in 1933-1934 for
which it was possible to obtain offering prices and values as of the close of
1938. Most of the initial offering data were taken from the Commercial
and Financial Chronicle . Following is a summary of the results covering
72 companies. The aggregate dollar values are derived from the number of
shares offered in each instance and not from the total capitalization
outstanding.

Dec. 31, 1938 price vs. offering price

Number

companies

Total value of shares
offered 1

At offering
price

At Dec. 31,
1938, price

Issues selling higher.. .

$ 6,211

$12,555

Issues selling lower.

30,533

5,918

Issues selling at same price. ...

346

S37,090

$18,819

1 000 omitted.

NOTE 66 (page 628 of text)

A series of discrepancies in the relative prices of securities of the Inter¬
borough Rapid Transit Co. (New York) securities, described herewith,
will exemplify the opportunities for analytical work of definite character
which are recurrently presented in the securities markets.

1. In November 1919 the 4 \i% bonds and the preferred stock of Inter¬
borough Consolidated Corp. both sold at 13. The bonds (called Inter¬
borough-Metropolitan 4J^s) were in default, and the company was in
receivership. The bondholders were entitled to claim ail the assets, which
had substantial value; the stockholders were without equity of any sort.
In the subsequent reorganization the preferred and common shares were
extinguished completely, while the 4H % bondholders received new securi¬
ties eventually worth considerably more than 13% of the face amount of
the bonds.

2. In January 1920, Interborough Rapid Transit Co. 7% notes, due
September 1921, sold at 64while the same company’s First and Refunding

APPENDIX

783

5s, due 1966, sold at 63^. Each 7% note was secured by deposit of about
$1,562 of 5% bonds and was convertible into about $1,144 of 5% bonds.
At the relative prices the notes were far more desirable than the bonds
because: (a) the notes enjoyed better .security; (b) they yielded a larger
return; and (c) their conversion privilege permitted the owner to benefit
from any advance in the price of the 5% bonds.

The notes were extended for one year at 8%; and in 1922 the holders were
offered $100 in cash and $900 in 7% secured, convertible notes, due 1932.
Those not accepting either offer were able to compel payment in full. An
exchange from 5s into 7s at the prices above indicated would have shown a
substantial profit at various times in 1921 and 1922.

3. In the early part of 1929, Interborough ilapid Transit Company
capital stock repeatedly sold at a higher price than Manhattan Ry. Co.
“Modified Guaranty” stock ( e.g ., 553^ for I.R.T. vs. 54 for Manhattan
Mod. Gty. in March 1929). This price relationship was illogical because:

а. “Manhattan Modified” was entitled to cumulative annual dividends
of 5%, and to payment of 6 34% accumulated, before Interborough stock
received anything.

б. “Manhattan Modified” was further entitled to receive a total of 7%
in the event that Interborough received 6%.

c. Interborough could not receive more than 7 % prior to 1950.

d. Dividends of 5% were actually being paid on Manhattan, while
Interborough was not receiving anything.

It should have been manifest that the Manhattan shareholders were cer¬
tain to receive at least as high a dividend as the Interborough shareholders
for the next 21 years. By August 1929, the price disparity was corrected,
for the “Manhattan Modified” stock sold 16 points higher than Inter-
borough (39 34 against 23).

4. In October 1933, I.R.T. 5% bonds and 7% notes both sold at 65.
This disparity was discussed in detail in Chap. I and referred to again in
Chap. LI.

5. In December 1932, Manhattan Ry. “Unmodified” shares sold at
18 while the “Modified” shares sold at 6Js- The stock was originally
entitled to dividends of 7%, guaranteed unconditionally by Interborough.
The modified shares were subject to an agreement under which payment of
dividends was contingent on earnings. However, the Plan of Modification
(adopted in 1922) provided that in the event of defaults by the Interborough
in the payment of taxes and bond interest under the Manhattan lease the
original terms of the guaranty would be restored with respect to the modified
shares. The Interborough was in receivership, and default under the
Manhattan lease was highly probable (and soon actual). Hence the price
relationship between the two classes of Manhattan stock appeared unjusti¬
fied in the light of the facts.

Under the Plan of Purchase by the city of New York, to be consummated
in 1940, the unmodified shares were given $35 and the modified shares $19,
respectively, in city bonds. As in the case of the I.R.T. 7s and 5s, it seems
that legal rights were sacrificed somewhat to expediency.

784

SECURITY ANALYSIS

NOTE 57 (page 532 of text)

In our 1934 edition we suggested that sixteen times average earnings should
represent the maximum investment valuation of a common stock. The
multiplier of 20, now suggested, reflects of course the much lower interest
rates on long-term borrowings. It may be objected that a drop in coupon
rates from to 2%% would justify a proportionate increase in the

common-stock multiplier from sixteen to about twenty-five times.

We should like, however, to call attention to two particular dangers in
raising price-earnings ratios pari passu with a decline in interest rates. The
first is that as the multiplier increases the greater becomes the number of
years in the future to which the investor must look before his purchase is
completely vindicated. A buyer at ten-times earnings might reasonably
envisage getting his money back out of profits within not too long a period,
after which he might consider himself “ operating on velvet.” This is a
familiar approach to an ordinary business venture, and it has a useful place
in stock investment. But as the multiplier advances, or the ratio of profits
to price declines, this period lengthens out to a span beyond both the inves¬
tor's patience to wait and his ability to foretell the future. Thus he becomes
basically dependent on the stock market to “keep him whole” or else on
increases in earnings to accelerate the paying-out process.

The second objection is based on the possible relationship between
interest rates and future earnings on invested capital. There is more than
a fair chance that if interest rates are to be permanently much lower than
heretofore, the rate of profit on investment will eventually fall as well. A
very liberal multiplier applied to past earnings may thus prove to be unwise,
because these earnings have not yet reflected the full consequences of the
fall in the long-term interest rate.

APPENDIX

785

NOTE 68 (page 686 of text)

We append herewith the tables used in our 1934 edition to illustrate
various types of common-stock purchases.

Group A: Common Stocks Speculative in July 1933 Because op Their

High Price

(Figures adjusted to reflect changes in capitalization)

Item

National Biscuit

Air Reduction

Commercial Solvents

Amount earned per share
of common:

1932

$2.44

$2.73

$0 51

1931

2.86

4.54

0.84

1930

8.41

6.32

1.07

1929

3.28

7.75

1.45

1928

2.92

4 61

1.22

1927

2.84

3.58

0.84

1926

2.53

3.63

0.69

1925

2 32

3 33

0.37

1924

2 18

2 81

0.45

1923

2 02

4.14

0.02(d)

10-yr. averages. ...

Pfd. stock.

$2.68

$ 35,000,000

$4.34

$0.74

Common stock.

Total capitalisation.

$368,000,000

$76,000,000

$75,000,000

Net tangible assets,

12/31/32.

$129,000,000

$29,200,000

$ 8,700,000*

Net current assets,

12/31/32.

36,000,000

9,800,000

6,000,000

Average earnings on com¬

mon-stock price.

5 1%

4 8%

2.5%

Maximum earnings on

common-stock price .

6.4%

8.6%

4 8%

* To this should be added an. allowance for the plant and equipment written down on the
books to $1. In 1920 these fixed assets were valued at about $3,000,000, net.

786

SECURITY ANALYSIS

Group B: Common Stocks Speculative in July 1933 Because or Their
Irregular Record

Item

B. F. Goodrich
(Rubber)

Gulf States
Steel

Standard Oil of
Kansas

Earned per share of com-

mon*:

1932

$ 6.73(d)

$ 3.94(d)

$0 23f

1031

8.01(d)

6.89(d)

1.93(d)

1930

8.65(d)

4 84(d)

1.19

1929

4.53

5.93

4.73

1928

1.50

6.28

0.91

1927

17.11

4.93

8.69(d)

1926

5.28

0 61

1926

23.99

7.17

1.64

1924

11 10

7.48

1.60(d)

1923

0.88(d)

12.79

0.88(d)

10-yr. average.

S 2.99

S 3.52

SO. 22

Bonds (at par).

< 43,000,000

S 5,200,000

Pfd. stock.

(294,000 sh. @ 38)

11,200,000

1,000,000

Common stock.

(1,156,000 sh. @ 15)

(198,000 sh. @28)

(269,000 sh. @20)

17,300,000

5,600,000

$5,380,000

Total capitalization.

S 71,500,000

$11,800,000

S5,380,000

Net tangible assets 12/31/32

105,300,000

27,000,000

5,290,000

Net current assets 12/31/32

43,700,000

2,230,000

3,980,000

Average earnings on com¬

mon-stock price .

19.9%

12.6%

1 1%

Maximum earnings on com¬

mon-stock price

160%

45 7%

23 7%

* Adjusted in column 1 to reflect actual changes in inventory values.
fO months ended Dec. 31, 1932.

APPENDIX 787

Group C: Common Stocks Meeting Investment Tests in July 1933
from the Quantitative Standpoint*

Item

S. H. Kress

Island Creek Coal

Nash Motors

Earned per share of com¬
mon:

1032

$2.80

$0.39

1931

4.19

1.78

1930

4 49

2.78

1929

5.92

5.05

6.60

1928

5.76

4 46

7.63

1927

6.26

5.64

8.30

1926

4.65

4.42

8.50

1925

4.12

3.22

5.57

1924

3.06

3.58

3.00

1923

3.39

4.08

2.96

10-yr. average.

Preferred stock.

$4 36

(372,000 sh. @ 10)

$ 3,700,000

$3.78

(27,000 sh. @ 90)

$ 2,400,000

$4.75

Common stock.

(1,162,000 sh. @ 33)
38,300,000

(594,000 sh. @24)
14,300,000

(2,646,000 sh. @ 19)
$50,300,000

Total capitalization.

*42,000,000

$16,700,000

$50,300,000

Net tangible assets,

12/31/32.

58,300,000

18,900,000

41,000,000

Net current assets,

12/31/32.

15,200,000

7,500,000

33,000,000

Average earnings on com¬

mon-stock price.

13.2%

15.8%

25.0%

Maximum earnings on

common-stock price .

17 9%

23.5%

44.7%

* Island Creek Coal and Nash Motors figures adjusted for stock dividends.

788

SECURITY ANALYSIS

Sequel .— The following summarizes the experience of a purchaser of each
of the aforementioned groups, measured to the end of 1930 and assuming an
equal dollar commitment in each of the common stocks listed.

Price
Dec. 31,
1939

Total
dividend
paid per
share

Result per $100 commit¬
ment

Divi¬

dends

received

Value
Deo. 31,
1939

Over-all

change

Group A.

National Biscuit .

22 H

$10.80

$20.6

$ 42 9

- 36.5%

Air Reduction .

170X*

35.60

39.2

189.0

+ 128.2

Com. Solvents.

2.85

9.5

46.6

- 43.9

$23.1

$92.8

+ 15.9%

Average annual dividend return....

3.85%

Group B:

Goodrich.

19 H

2.00

$13.3

$131.0

+ 44 3%

Gulf States Steel.

55f

196.4

4- 9fi 4

Standard Oil of Kansas .

48 ;

10.00

50 0

240 0

Average per $100.

$21 1 !

$189.1

+ 110 1%

Average annual dividend return..

3.52 %

Group C:

Kress. .

57 Ht

19.10

$57.8

$173.5

+ 131.3%

Island Creek Coal.

25>*

12.50

52.1

105.2

+ 57 3

Nash Motors.

3.88

20 5

34 9

- 44 6

Average per $100.

$43 5

$101.2

+ 44 7%

Average annual dividend return..

7.25%

* Allowing for 3-for-l split-up.

t Allowing for exchange into Republic Iron and Steel common.
X Allowing for 2-for-l split-up.

The performance, as summarized above, suggests the following brief
observations:

1. The best over-all result was shown by Group B , an obviously specula¬
tive selection. This must be considered an accidental outcome; another
trio of such stocks might have behaved entirely differently during this
period.

2. By far the best dividend return was realized on Group C. This is
likely to be true generally for this type of issue as against the others.

3. The market-price changes in Groups A and C cannot be considered as
indicating any inherent qualities of these types, in view of the small sample
taken. The importance of qualitative factors in selecting Group C issues
is brought home by the poor performance of Nash Motors. This point is
(and was) emphasized in our text by the sentence “But the actual purchase
of any such issues (in Group C) must require also that the purchaser be

APPENDIX 789

satisfied in his own mind that the prospects of the enterprise are at least
reasonably favorable.”

NOTE 59 (page 548 of text)

For the operation of leverage in reverse fashion see the following with
respect to American Water Works & Electric Co.:

American Water Works and Electric Company 1

Item

1929

1938

Ratio of 1938
figures to
those for
1929, %

Gross revenues.

$54,119

$50,004

92.40

Net for charges.

22,776

17,593

77.20

Fixed charges and preferred dividend.’

16,154

16,698

103.37

Balance for common stock.

6,622

895

13.52

Number of shares of common... .

1,657

2,343

141.41

Earned per share of common.

$ 0.38

9.50

High price for common.

199

8.10

Minimum earnings per share of com¬

mon since 1929.

$0.38 (1938)

Minimum price of common since 1929

6 (1938)

1 Figures in thousands, except those per share.

For a speculative opportunity similar to that of American Water Works
as presented in the text, see the following:

The United Light and Power Company 1

Item

1934

1937

Gross revenues.

Net for charges.

$73,867

19,905

18,918

$89,531

23,404

17,932

289

Fixed charges.

Surtax.

Balance for preferred stock.

Earned per share of preferred....

987

$ 1.64

5,183

$ 8.64

1 Figures in thousands, exoept those per share.

In 1935 the $6 Cumulative Preferred stock of United Light & Power Co.
sold at per share, or a total valuation for the issue of $2,100,000, junior
to funded debt of the system and preferred stocks of subsidiaries totaling
$329,422,455. The magnitude of this heavily pyramided structure as
measured by gross revenues and senior capitalization made it apparent that
even a slight improvement in net for charges would greatly enhance the

790

SECURITY ANALYSIS

earnings of the parent company preferred stock. By 1937 the price of this
issue had risen to 75% from the low of 3% in 1935. The high price for the
preferred issue as early as 1936 was 68.

NOTE 60 (page 557 of text)

The sequel to this example (presented as above in our 1934 edition) may
be of interest.

The rise in the price of gold advanced the sales of Wright-Hargreaves to
between 7 and 8 millions and increased the earnings before depletion to
about 72 cents per share in each of the years 1934-1938. The stock rose
to a high of 10.30 in 1934 and sold at 5% at the end of 1939.

Recovery from depression increased the sales of Barker Bros, to $14,314,-
000 in 1937. In 1936 net earnings reached $666,000, equal to $23.67 per
share of preferred and $3.36 per share of common. After regular preferred
dividends adjusted to reflect the recapitalization of 1936 which disposed of
accumulated preferred dividends, these earnings were equivalent to $2.67
per share of common. The price of the preferred advanced to 131 in 1936
and to the equivalent of 140 in 1937, and the common reached a high of 32 in
1937. At the end of 1939 the common sold at 8%; the preferred at the
equivalent of 80. Note that the preferred proved a much better speculation
than the common—a characteristic feature of low-priced senior issues in
relation to their common stocks.

NOTE 61 (page 661 of text)

PRICES, EARNINGS AND ASSET VALUES OF INDUSTRIAL
COMMON STOCKS

A Comprehensive Study of the New York Stock Exchange List in 1938

At the close of 1938 all the common stocks listed on the New York Stock
Exchange were selling for about 41 billion dollars. This value was just
midway between the high point of 55 billions in March 1937 and the low
point of 27 billions recorded a year later. There has been apparently little
disposition in Wall Street to regard the 1938 year-end price level as either
too low or too high in relation to intrinsic worth, and in fact the values a
year later were very nearly the same. Hence the common-stock market in
December 1938 would seem to lend itself quite well to a study of postdepres¬
sion standards of value, or—in any event—of the relationships existing at
some not abnormal time between the prices of various groups of common
stocks and their earnings and asset values. A survey of this kind, covering
virtually all the industrial stocks listed on the New York Stock Exchange,
was made in early 1939 by students of the Columbia University School of
Business under the direction of the authors. The results of their work are
summarized and subjected to brief analysis in this Note. 1

The study dealt with 648 common stocks out of a total of 823 listed on the
Exchange on Dec. 31, 1938. Besides 71 railroad and 46 utility issues,

1 Cf. the interesting series of comparative analyses of industrial groups issued by the
8.E.C. in 1938-1040. entitled Survey of American Listed Corporations. These are based on
income account and balance sheet items only and give no data relating to market values.

APPENDIX

791

Tablb I.—Total Figures in Millions Covering 648 Industrial Com¬
panies Compared with 30 Large Companies in Dow-Jones Indus¬
trial Average 1

Item

648 companies

30 companies
in Dow-Jones
ind. average

Dec. 31, 1938:

Market value of common stock

$32,412

114,771

Tangible assets for common

21,980

7,922

Net current assets for common

2,606

811

Bonds (at par) and preferred stock (at market)..

8,029

2,727

Total capitalization. .

40,441

17,498

Year 1938:

Sales.

27,460

7,896

Depreciation.

1,198

433

Net before bond interest

1,595

652

Interest and preferred dividends

442

116

Balance for common

1,153

536

Common dividends paid

1,109

435

Balance for common-average 1936-1938

1,953

850

average 1934-1938. ..

1,642

722

Market value of common at:

1937-1938 high .

48,216

20,364

1937-1938 low...

19,898

9,299

Total capitalization at:

1937-1938 high...

56,774

23,065

1937-1938 low

26,862

11,552

Dec. 31, 1938:

Cash assets.

4,359

1,528

Receivables

3,195

785

Inventories

6,073

2,165

Other current assets

Total current assets

13,640

4,478

Total current liabilities

2,694

926

Net current assets

10,946

3,552

Fixed and other assets

about 20,000

8,236

Ratios:

Dec. 31, 1938 market price of common to:

Tangible assets for common

147%

186%

Earnings for common 1938

28.1 times

27 5 times

Earnings for common 1936-1938 av

16.6 times

17 4 times

Earnings for common 1934-1938 av

19.8 times

20 4 times

Current assets to current liabilities

5.0 times

4 8 times

Depreciation to sales

4.3%

5 5%

1 The authors estimate that the aggregate market price of the 648 common stocks at the
end of 1939 was about 3 % lower than at the end of 1938, or about I31>$ billions; and that
earnings available for the common were about 1,830 i. .llions. It thus appears that indus¬
trial common stocks at the end of 1939 were selling in the aggregate at about 17.2 times their
1939 earnings and about 18.8 times their 1934-1939 average earnings.

Table II.—Subtotals by Industrial Groups

792

8BCURITY ANALYSIS

APPENDIX

793

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No tangible assets for common. Percentage earned on tangible assets for preferred and common was 11.5%,

794

SECURITY ANALYSIS

Table III.— Totals Divided According to Size op Company
A. Size Measured by Selling Price of Company at End of 1938

Sise

(1)

Num¬
ber of

com¬
panies
in group

(2)

Com¬

mon

stock at
market
(mil¬
lions)

(3)

Tangible
assets
for com¬
mon
(mil¬
lions)

(4)

Ratio
of col¬
umns 4
to 3, %

(5)

% earned on 1938
price of common

% earned
on tan¬
gible
assets for

common

1934-1938

(9)

1934-

1938

(6)

1936-

1938

(7)

1938

(8)

Less than 10 millions

252

968 0

1,323.9

136.8

3.4

5.0

(d)

2.5

10-100 millions .

7,292.4

5,575.4

76.4

5.3

2.9

6.9

100-1000 millions .

17,016 1

HMffilEl

66.7

5.3

6.2

4.5

7.9

Over a billion.

7,135.9

3,712.4

4.6

5.5

8.9

B. Size Measured by Net Tangible Assets at End of 1938

Size

(1)

Num¬
ber of

com¬
panies
in group

(2)

Com¬

mon

stock at
market
(mil¬
lions)

(3)

Tangible
assets
for com¬
mon
(mil¬
lions)

(4)

Ratio
of col¬
umns 4
to 3, %

(5)

% earned on 1938
price of common

% earned
on tan¬
gible
assets for

common

1934-1938

(9)

1934-

1938

(6)

1936-

1938

(7)

1938

(8)

Less than 10 millions.

250

1,493.0

951.1

63.6

4.9

6.0

2.4

7.7

10-100 millions.

331

10,454 5

6,761 4

64.4

4.9

5.8

3.0

7.6

100-1000 millions.

16,303.5

11,321.6

69.4

5.1

glPl

4.2

7.3

Over a billion.

4.1G1.4

2,946.0

5.5

6.7

3.0

7.8

All companies.

648

32,412.4

21,980.1

67.6

5.1

6.0

3.6

7.5

there were excluded the shares of 27' financial companies and 16 foreign
companies as well as 15 dormant or otherwise unsuitable enterprises. The
industrial shares covered by our analysis had an aggregate value of 32.4
billions at the close of 1938—or nearly 80% of the value of all the listed
common stocks. (It is interesting to note that the value of all the railroad
common shares, including holding companies, was less than 6% of the 41.3
billion total.)

The two major factors covered by our study were the following:

1. Relation of market price to earnings for 1938, 1936-1938 and 1934-
1938.

2. Relation of market price to 1938 tangible asset values and net current-
asset values.

In addition to these central elements we compiled data concerning:

3. The relation of 1938 sales (i.e., gross business) to common-stock prices
and earnings.

APPENDIX

795

Tab lb VI. —Range of 1934-1038 Eabninos on Invested Capital 1
within Certain Industrial Groups

Num-

% earned on invested capital

Industrial group

ber of

com¬

panies

Individual members
of group

Group

group

Maxi¬

mum

Mini¬

mum

Median

total

Soft drinks.

59.4

5.3

5.5

39.8

Gold mining.

33.4

9.8

15.4

21.1

Drug mfrs.

30.7

id)

12 9

19.6

Confections.

31.9

(d)

19.7

18.2

Misc. retailers.

22.8

(d)

17.9

18.0

Soaps.

Mining (except gold, iron and

34.0

5.2

14.4

11.9

copper).

152.0

id)

8.2

10.6

Light machinery.

44.2

(d)

9.3

8.9

Misc. chemicals.

42.3

(d)

9.9

Motion pictures.

42.2

3.5

| 7.7

8.2

Trucks.

17.4

(d)

0.7

1.5

Wool and carpet.

14.7

(d)

3.2

1.5

Shipbuilding and operating.

7 !

4.8

(d)

2.4

1.4

Engineering and building.

2.8

(d)

0.8

Leather.

Total of above.

5 !
164

6.1

(d)

1.5

(d)

All companies.

648

152.0

(d)

6.3

7.0

1 Invested capital is taken at the end of 1938 and represents net tangible assets available
for bonds and stocks.

4. The working-capital ratio; the relation of working capital to sales; the
division of current assets between cash assets, receivables and inventories.

5. The amount of senior securities outstanding and the charges thereon.

6. Depreciation allowances in relation to sales and fixed assets.

In this Note the data collected have been grouped in accordance with two
principles of division. On the one hand, we have a separation by industries,
as in the tables supplied monthly in the New York Stock Exchange Bulletin.
We have found it advisable to modify the bulletin's classifications somewhat,
shifting a few individual companies and subdividing a number of groups
which otherwise would be too inclusive to be really informing. We have also
divided our total into gradations of size, measuring the latter (1) by invested
capital and alternatively (2) by the total value of all outstanding securities. 1

1 In all these calculations common and preferred stocks have been valued at market price,
but bonds have been taken at par. Although market prices for bonds also would have fur¬
nished a more exact measure, the difference at stake did not warrant the additional labor
required.

796

SECURITY ANALYSTS

This grouping gives us four classes; small companies, worth less than 10
millions; medium-sized companies, worth between 10 and 100 millions;
large companies, worth between 100 millions and 1 billion; and a few giants,
worth over a billion dollars each.

Nearly all the information to be supplied in this paper is presented in the
various Tables I to VI appended. In addition to the main body of data,
which use the Dec. 31, 1938 values as their base, we have also compiled the
maximum and minimum stock values during the 1937-1938 period. The
wide spread between these extremes—which were just 12 months apart in
point of time—and the relationship that they presented to assets and earn¬
ings may throw an interesting light upon the character of the stock market
in recent years.

Comments on the Totals for 648 Companies

Perhaps the most striking figure in the entire study is the total tangible
assets available for common stock (Table I). This amounts to 22 billions
compared with 32.4 billions of market value. Despite the general feeling
that business has been unsatisfactory on the whole since 1930, despite the
definitely poor results of 1938 and despite the reputed lack of confidence
that is widely given as the reason for the failure of American business to
attract new capital, investors were still willing to pay for industrial common
stocks as a whole in 1938 and 1939— about 50% more than the tangible capital
that they represented.

But this characteristic of the entire aggregation is by no means common
to the vast majority of individual companies. No less than 307 concerns—
or 47% of the total—were selling for less than tangible asset value. The
same was true of 28 industrial subdivisions out of a total of 67.

When we study the groupings by size (Table III), we find that the small
companies, measuring them by their market value t sell in the aggregate for
much less than tangible assets, whereas the larger categories sell at so much
more than asset value as to create the 50% premium for the grand total of all
companies. It might appear from these figures that the small company, as
such, is definitely at a disadvantage or a discount. Curiously enough, such
is not the case. The small companies, in terms of tangible assets, actually
sell at a higher premium than the others (Table IIIB). What has happened,
in effect, is that the group selling for less than $10,000,000 is heavily weighted
by companies with fairly large tangible assets which sell for little because
they are unsuccessful. In other words, the small-company group, in terms
of market value, has a definite bias on the side of poor earnings and conse¬
quent low market value in relation to assets. The correct explanation of
the large over-all premium, in the face of so many companies selling at a
discount, seems to be merely that the premium paid for the typical successful
company averages much higher than the discount registered by the unpopu¬
lar concerns.

It may be noted also that 54 individual companies, or 8% of the total,
sold for less than net current assets alone at the end of 1938. At the 1937-
1938 lows this was true of no less than 133 companies, or 1 out of 5. At the
1937-1938 highs there was not a single company in this situation.

APPENDIX

797

Price-earnings Ratios

Our study of earnings covered the one, three and five years ending with
1938. As far as any concept of a “normal/' or representative, period can be
formed, the five-year earnings appear most suitable—since 1938 alone was
undoubtedly a poor year, and the 1936-1938 triennium may be a little too
heavily weighted by prosperous conditions. On this point the reader must
form his own conclusions. In any event it will be seen that the listed
industrial common stocks were valued at the end of 1938 at 19.5 times their
average earnings in the five years preceding (a 5.1% earnings basis) and at
16.6 times their three-year average (a 6% basis). On the 1938 results alone
the multiplier rises to 28 times, and the earnings yield falls to 3.6%. But,
again, analysis of the individual figures will show a tendency for the liberal
prices accorded the shares of the successful companies to obscure, in the
totals, a large number of concerns that were selling at very modest figures in
relation to their earnings record.

Characteristics op Industrial Groups

The division of the 648 companies into industrial categories must neces¬
sarily be in good part a matter of arbitrary choice. The New York Stock
Exchange Bulletin allocated these companies to 27 groups; we found it advis¬
able to subdivide these further into 67 families. Of these the largest, in
terms of market value, was the oil group—followed by heavy chemicals and
automobiles. The top seven families, comprising 111 companies, were
worth 19.3 billions, or 53% of the total.

Table II shows in detail the wide range of performance of the 67 subgroups.
The following supplementary classifications may be of interest:

Table IV.— Industrial Groups Divided on Basis of Ratio of Market
Price to Asset Value

Market price +
asset value

Number

groups

Number
of com¬
panies
in group

Earned c

1934-1938

>n 1938 ma
rice, %

1936-1938

,rket

1938

Over 400%.

4.7

5.2

200-400%.

166

4.8

5.4

3.6

100-200%.

189

5.9

■ 1 ■

4.4

60-100%.

234

4.9

3.0

Less than 50%.

1.1

def.

Total.

648

5.1

6.0

3.6

It will be noted that the very highest priced groups, in comparison with
asset values, were also priced higher than the average of all companies in
terms of earnings, except for the reeulte of 1988 alone. The ability of these

798

SECURITY ANALYSIS

companies to do better in the recent poor year than for the five-year average
is undoubtedly the key to their popularity. At the other end of the spec¬
trum we find, of course, that the companies selling at very low prices in
relation to assets made a very poor earnings exhibit as a whole. On the
other hand, the 20 groups selling at between 50 and 100% of asset value did
not do appreciably worse from the profit viewpoint than the divisions selling
at premiums, unless especial emphasis is to be laid on the 1938 performance.
Peculiarly enough, the groups selling between two and four times asset value
made a poorer showing from the earnings standpoint, in each period, than
those selling between one and two times assets. Note that the figures given
in Table IV relate to group totals only. Each of these may include individ¬
ual companies that diverge widely from the characteristics of the total.

Trend of Earnings

The variation in the results for the one-, three- and five-year period pro¬
vides a simple and rather persuasive test of earnings trends. Companies
or groups meeting the formula 1938 > 1936-1938 > 1934-1938 would be
exceptional on the side of improvement, whereas those meeting the opposite
formula 1938 < 1936-1938 < 1934-1938 would stand out as retrogressing.
When this criterion is applied, we find the following candidates for special
honors or dishonors:

Groups with good trend

Groups with bad trend

Groups showing 3 deficits
for common

Aviation

Business and office

Coal

Cigara

equipment

Engineering and build-

Flour, bread, cereals

Can manufacturing

ing

Soft drinks

Canned goods

Land and hotel

Cotton goods

Leather

Meat

Shipbuilding

Rayon

Shipping services

Restaurant

Retail grocer

Shoes

Snuff

Vegetable oils

Distillers 1

Gold 1

Wool

1 Downward trend very slight.

Students of the market will recognize certain relatively popular groups in
the poor-trend list and two unpopular groups in the good-trend list. The
chief value of this type of study may be to generate a healthy scepticism
as to the dependability of a mere arithmetical upward trend as a basis for
bullish enthusiasm.

APPENDIX

799

The following compilation (Table V) covers the five subgroups showing
the highest ratios of earnings to December 1938 price in each of the three
test periods, as compared with those showing the lowest ratio of assets to
price.

Table V.—“Cheap” Groups (on Earnings Basis) Compared with
“Dear” Groups (on Asset Basis)

Num¬
ber of

com¬

panies

Aggregate

common

stock

value

(millions)

Ratio to 1938 common
stock value of

Assets,

or
/ 0

Earnings, %

1934-

1938

1936-

1938

High earnings-ratio group 1 .
Low asset-ratio group 2 .

907.2

1,404.9

■

10.9

4.7

11.9

5.2

9.0

5.2

1 Includes: brewers and distillers, milk, misc. tobacco, motion pictures, retail drugs,
retail grocers, sugar, vegetable oils.

* Includes: drug mfrs., confections, radios, etc., and soft drinks.

It will be noted (from Table II) that none of the groups selling at cheap
prices in relation to average earnings did worse than the 648 company total
in the poor year 1938. Furthermore, their price was also low in comparison
with asset values. There is thus a sharp contrast between this set of com¬
panies and those, already mentioned, which were selling at more than four
times tangible asset value. The latter include radios (3 companies), drug
manufacturing (13) confections (6) and soft drinks (3). Note that the
“cheaper” stocks offer 8 times as much in asset value, per dollar of price,
2.3 times as much in 1934-1938 earnings and even 1.73 times as much in
1938 earnings, as do the low-asset stocks. Statistically, the sole advantage
of the latter group is found in the 11% increase of 1938 earnings over the
five-year average, as compared with a 17% decrease for the other set. But
it should be pointed out that the improvement shown by the “dear”
stocks was largely accounted for by one company (Coca-Cola) and also
that the 1938 earnings of the “cheaper” group were relatively much better
maintained than those of the Stock Exchange list as a whole.

The contrast offered by these two groupings is accentuated by certain
broad similarities existing between the categories in one and in the other.
Radios and broadcasting invite comparison with motion pictures, drug
manufacturing with drug stores, confections with sugar, and soft drinks
with both milk and liquor. The outstanding contrast of all is presented by
Coca-Cola on the one hand (dominating the soft-drink field) and all the other
listed beverage companies, selling milk, soft drinks, beer and whisky.
These 14 common stocks, taken together, were worth only two-thirds as
much as Coca-Cola alone—but their 1938 sales were 970 millions against

800

SECURITY ANALYSIS

76 millions, their 1938 net for common 52.8 millions against 23.8 millions,
and their tangible assets for common stock 390 millions against only 16
millions.

Earnings on Invested Capital

Study of price-earnings ratios may be supplemented by examination of
the percentage earned on invested capital, i.e ., tangible assets available either
for the common stock or for all capital securities. For this purpose we have
taken average results for 1934-1938, as perhaps the most representative
index, and compared them with the invested capital at the end of 1938,
including therein the funded debt. The results are summarized in Table II
for the various industrial groups and in Table IILA and B for various
divisions by size of company.

Certain aspects of these exhibits deserve comment. Since large earnings
on invested capital may be accepted as one of the best proofs of a prosperous
business, it is natural to scrutinize that ratio for a clue to the relative
profitableness of the several branches of industry. Taking the aggregate
results of each of our 67 subdivisions, we find indeed wide variations,
ranging from 39.8% on capital for the soft-drink companies down to an
actual deficit for the leather concerns.

But just as striking as this diversity are variations within the individual
groups. This point is brought out in Table VI, which lists the maximum,
minimum and median percentages within, as well as the over-all figure for,
those groups which show the five largest percentages under each heading.
(We give similar figures covering the five lowest group totals.) It will be
noted that many of the divisions making the best showing as a whole
include individual companies that earn nothing at all or very little—and,
to some extent, the converse is also true.

These divergences within industry groups should go far to temper the
natural inclination for investors and analysts to attach dominant merit or
demerit to the line of business. That the type of industry is of great sig¬
nificance in judging a common-stock issue goes without saying; but snap or
extreme judgments based on this factor alone may often prove unsound.

When the classification is made by size, some interesting facts develop.
The main point is that average earnings on capital (i.e., tangible assets
available for bonds and stocks) run almost identical for all five groupings,
beginning with companies smaller than 10 millions and running up to the
giants which overpass a billion dollars. Furthermore, the smallest con¬
tingent actually sells at a slightly higher price than the others in relation
to asset values.

But if we apply the identical classifications to market values, instead of
to tangible asset values—as we do also in Table 1114—an entirely different
situation develops. The small companies are found to be least profitable,
although they have proportionately far greater assets and sales. The
reason is not far to seek. Their market value is small because they are
unprofitable, and not vice versa . These two sets of comparisons suggest
that the pressure on the smaller businesses has not yet become so serious
as to reduce their earning power on capital in the aggregate below that of their

APPENDIX

801

larger competitors. 1 But that the individual small business is more vul¬
nerable to adversity and that the widest range of performance is to be found
in this class is hardly open to question.

NOTE 62 (page 681 of text)

The following is a representative list of preferred and common stocks
which sold for less than their net current assets per share at their low prices
during 1931 and the first four months of 1932. Most of these issues sold
at still lower prices later in 1932.

Company

1931-
April 1932

Cur¬

rent

asset

value

per

Pre¬

ferred

Cur¬

rent

asset

value

per

Com¬

mon

1932-1933
low price

Low

price

Pre¬

ferred

Low

price

Com¬

mon

Pre¬

ferred

Com¬

mon

Allis-Chalmers.

$11

Amer. Agric. Chem.

4 %

California Packing.

Diamond Match.

19%

10H

$ 43

20%

Endicott-J ohnson.

98%

23%

276

Liquid Carbonic.

11%

Mack Truck.

36K

Mid-Continent Petrol..

\“

l^\

Montgomery Ward.

462

NatT Cash Register.. ..

....

U.S. Indus. Alcohol....

19%

23M

....

13%

U.S. Pipe & Foundry...

12 %

10K

Wesson Oil.

44%

Westinghouse Air Brake

Westinghouse Electric..

60%

19%

1,164

34%

62%

16%

1 See a detailed study by Simon N. Wbitney, entitled " Statistics Disprove Assertion that
Giant Companies Squeeze Out Small Rivals," published in the Annalist, Dec. 28, 1939; his
figures, leading to the same conclusion as above, are based in part on census data and thus
cover a wider range. For an opposing viewpoint see E. V. Kennedy, Dividends to Pay , 1939.

802

SECURITY ANALYSIS

A similar list of stocks which at their low price during the first five months
of 1932 sold at or below their cash assets per share (not deducting current
liabilities) is given below.

Company

Low

price

Jan.-

May

1932

Cash

assets

per

Current

asset

value

per

1932-

1933

low

price

Amer. Car & Foundry*.

$ 50

$108

Amer. Locomotive*_

30 a

17 H

Amer. Steel Foundries*.

128

186

Amer. Woolen*.

15H

30 H

15M

Congoleum-Naim.

6 H

Howe Sound.

Hudson Motor.

2Vs

5 x

Hupp Motor.

i H

Lima Locomotive.

8 M

Magma Copper.

4 H

Marlin Rockwell.

5 H

Motor Products.

15K

Munsingwear.

Nash Motors.

13 H

New York Air Brake.

4 H

Oppenheim Collins.

Reo Motor.

1 H

Standard Oil of Kansas.

Stewart Warner.

White Motor.

6 H

* Preferred stock.

These examples have been taken from several articles by one of the
authors dealing with this phenomenon. See Graham, Benjamin: “Inflated
Treasuries and Deflated Stockholders,” Forbes , June 1, 1932, p. 11; “Should
Rich Corporations Return Stockholders’ Cash,” Forbes f June 15, 1932, p.
21; “Should Rich but Losing Corporations Be Liquidated,” Forbes , July 1,
1932, p. 13. The 1932-1933 low prices are added to complete the picture.

NOTE 63 (page 639 of text)

The analyst must frequently calculate the relative values of subscription
rights and the common stock covered thereby. To facilitate this calcu¬
lation we append two simple formulas.

Let R ■» value of right.

M *= market price of stock.

S ■■ subscription price of stock.

N « number of rights needed to subscribe to one share.

APPENDIX

803

Formula A, applicable before stock sells “ex-rights’* (i.e., the purchaser
of the stock will be entitled to receive the rights).

M - 8

JV + 1

Formula B, applicable after the stock sells “ex-rights” ( i.e ., the purchaser
of the stock does not get the rights, which are retained by the holder
of record).

Example: Rights are given to buy one share of stock at 50 for each five
shares held. Stock is selling at 64 “with rights” (“rights on” or “cum
rights”).

Value of right « p = $2.33

o + l

Example: Same offer; stock is selling “ex-rights” at 90.

Value of right = - $9 ° ~- S - ° = $8

These calculations are subject, however, to necessary refinements to
reflect: (1) any dividend to be received by the old stock but not on the new
shares; and, contrariwise, (2) any saving in interest by reason of not having
to pay for the new stock until the rights expire.

NOTE 64 (page 659 of text)

TWO EXAMPLES OF CORPORATE PYRAMIDING

First Example: The essential character of the Insull pyramid may be
brought out by the following partial summary:

Liabilities senior to common stock
(Dec. 31, 1931)

Company 1

(Top Company) Corporation Securities Co. An Bank loans, etc .. $33,000,000

investment company of special- Funded debt . 24,000,000

ized character. Its chief hold- Preferred stock. 37,000,000

ings were in Co. 2—$59,000,000
and Co. 3—$42,000,000, out of
total portfolio of $145,000,000.

Company 2 Insull Utility Investments, Inc. Bank loans, etc.$53,000,000

Also a specialized investment co. Funded debt... 58,000,000

Its ohief holdings were in Co. 3 Preferred stock. 46,000,000

—$64,000,000 out of total port¬
folio of $252,000,000. (It also
held $32,600,000 of stocks of Ca
1 .)

804

8ECURITY ANALYSIS

Company 8

Liabilities senior to common atook
(Deo. 31, 1931)

Middle West Utilities Co. A Parent company:

publio utility holding oompany Bank loans, eto. $35,000,000

controlling a number of sub- Funded debt. 40,000,000

systems. Gross business of sys¬
tem in 1931 was $173,000,000.
Chief subsidiary was Co. 4.

Company 4 National Electrio Power Co. A Parent company:

public utility holding company Bank loans, etc Not reported

controlling several subsystems. separately

Gross business in 1931 was Funded debt $10,000,000

$68,000,000. Chief subsidiary Pfd. & Class A stock 30,000,000

was Co. 5.

Company 5 National Publio Service Corp. Parent company:

A publio utility holding com- Bank loans, etc Not reported

pany controlling four subsys- separately

terns. Gross business in 1931 Funded debt .. . $20,000,000

was $36,000,000. Chief sub- Pfd. & Class A stock 30,000,000

sidiary was Co. 6.

Company 6 Seaboard Publio Service Co. A Parent Company:

public utility holding company Funded debt .. None
controlling six subsystems. Preferred stock $9,000,000

Gross business in 1931 was
$16,000,000. Chief subsidiary
was Co. 7.

Company 7 Virginia Public Service Co. A Funded debt.$37,000,000

publio utility operating and Preferred stock 10,000,000

holding company. Gross busi¬
ness in 1931 was $7,600,000.

Note that a pyramided structure of six successive holding companies was
built above the various operating companies in this system. The complete
collapse of this structure is shown by the fact that every one of these six
superposed holding companies was thrown into bankruptcy. For descrip¬
tion, charts and discussion of the Insull Group see James C. Bonbright and
Gardiner C. Means, The Holding Company , pp. 108-113, New York, 1932.

Second Example: The United States and Foreign Securities Corp. set-up
provides a fairly simple demonstration of the workings of a pyramided
structure in the general investment trust field.

This company was organized in 1924. The public bought $25,000,000 of
$6 First Preferred at par (the company receiving $24,000,000), and the
organizing bankers bought $5,000,000 of $6 Second Preferred at par. The
1 ,000,000 shares of Common Stock, representing a purely nominal invest¬
ment (10 cents per share), were divided: 25% to the public, and 75% to the
organizers. Thus the latter supplied one-sixth of the capital, subordinated
to the other five-sixths, and received a three-quarters interest in the surplus
profits. Toward the end of 1928, the holding company form of pyramiding
was utilised by the formation of a second company, U.S. & International

APPENDIX

805

Securities Corp., a $60,000,000 enterprise. The public contributed $50,-
000,000 of the capital, receiving $5 First Preferred Stock at 100, plus
one-fifth of the Common. United States & Foreign Securities Corp. contrib¬
uted $10,000,000, receiving $5 Second Preferred at 100, plus four-fifths of
the Common. This arrangement gave the organizers of the original com¬
pany control over the additional funds subscribed without further invest¬
ment on their part. Because of a $30,000,000 appreciation in the resources
of U.S. & Foreign Securities Corp., the end of 1928 found the contributors

A. Period 1924-1928

Item

Total

Public’s

Organizers'

Original investment.

$ 30,000,000*

$25,000,000

$ 5,000,000

Book value, December 1928.

60,000,000

32,000,000

27,000,000

% increase in book value.

Maximum market value of U.S. &

100 %

30%

450%

Foreign capitalization f.

100 ,000,000

42,000,000

57,000,000

% Increase in market value....

233%

70%

1,040%

* Company received $29,000,000.

t Firet Preferred @ 100; Second Preferred estimated @ 80; Common @ 70.

B. Period 1928-1939

Results are shown per $100 of original investment, because of decrease in
First Preferred Stock outstanding due to repurchases by the company.

Date

Public’s i
investment

Organizers’

investment

Book value:

Dec. 31, 1928

$130*

$550

Dec. 31, 1932

100 *

Dec. 31, 1933.

100 *

96 f

Dec. 31, 1939 .

108*

215

* First Preferred at par, plus liquidating value of attached common,
f Exclusive of claim for accumulated Second Preferred Dividends.

Date

Public’s

invest¬

ment*

Organ¬
izers’ in¬
vestment*

1 st Pfd.

Common

Market price:
High, 1929..

$170

$1,150

100

Low, 1932...

27K

ii H

1 H

Dec., 1933...

Dec., 1939...

165

♦Per $100.

806

SECURITY ANALYSIS

of the original $5,000,000 now controlling $110,000,000 of capital (including
subscriptions callable) and entitled to about 78% of the surplus profits or
enhancement thereof.

The actual operation of this arrangement from the standpoint of both
book value (“break-up value”) and market quotations is shown by the
tabulation on page 805.

These figures show typical results for a highly speculative capital struc¬
ture under both favorable and unfavorable developments. It will be noted
that the variations in book or break-up value were greatly intensified in
the market by the excessive optimism and pessimism of the public's
attitude toward investment trust securities. It is significant to observe also
that when a book value about equal to the original investment per share was
reestablished, in 1933, the market registered a substantial depreciation for
the public’s part of the capital and a corresponding premium for the organ¬
izers' interest.

NOTE 65 (page 662 of text)

A few instances of control with relatively small investment are as follows:

1. An investment of less than $20,000,000 by the Van Sweringen interests
gave control of eight Class I railroads with combined assets of over $2,000,-
000,000. Thus an investment of less than 1 % controlled the entire system.
See F. I. Shaffner, The Problem of Investment , p. 38, New York, 1936. See
also pp. 659-661 supra for further details of the Van Sweringen pyramid.
Subsequently Messrs. Ball and Tomlinson bought this control on a bankrupt
basis for $3,000,000.

2. Prior to 1935 Henry L. Doherty & Co. had 27 % of the voting power of
Cities Service Co. through ownership of 1,000,000 shares of $1 par preferred
stock which had multiple voting rights as contrasted with the common stock.
This arrangement, plus a pyramided capital structure, enabled the $1,000,-
000 of preferred stock to control a corporation with consolidated assets of
over $1,250,000,000. See James C. Bonbright and G. C. Means, The
Holding Company , pp. 113-114, New York, 1932.

3. Prior to 1930 the Standard Gas and Electric System with consolidated
assets of $1,200,000,000 was controlled by H. M. Byllesby & Co., mainly
through ownership of 1,000,000 shares of $1 par preferred stock similar to
that of Cities Service Co. (ibid r p. 115). Subsequently a reshuffling of the
capital structure took place, and thereafter an equity interest of $3,000,000
or less had a more complete control over this $1,200,000,000 utility system
(ibid, p. 116).

4. Stock having a book value of $8,000,000 and a still smaller market value
once controlled the billion-dollar Associated Gas & Electric system (ibid,
p. 122). During the course of the hearings preceding enactment of the
Public Utility Holding Company Act of 1935 it was revealed that Messrs.
H. C. Hopson and J. I. Mange, occupying a position at the top of the heap
of those in control of this system, obtained through the pyramided holding
company device an annual average return during 1923-1929 of 60.82%
applicable to their total investment of $298,318. See Hearings on H. R .
5423, before the House Committee on Interstate and Foreign Commerce,
pt. 2,74th Congress and 1st Session, pp. 1473-1476, Washington, D. C., 1935.

APPENDIX

807

6 . Through six layers of holding companies the Insull interests controlled
the Tide Water Power Co. by an investment of only 0.02% of the total
investment in the latter company, as measured by the book value of its
outstanding securities. This amounted to control of $5,000 on an invest¬
ment of $1. Similarly, a $2.50 investment at the top by the Insull interests
enabled them to control a $5,000 investment at the bottom of the pyramid
in Florida Power Corp. through six layers of holding companies. See Utility
Corporations , Sen. Doc. 92, pt. 72-A, 70th Contress and 1st Session, pp.
159-161, Washington, D. C., 1935.

NOTE 66 (pages 169, 674, and 703 of text)

ANALYSIS OF CHICAGO, MILWAUKEE, ST. PAUL AND PACIFIC
RAILWAY GENERAL MORTGAGE BONDS (VARIOUS SERIES),

DUE 1989

Average Price in 1939 about 25

This issue, carrying various interest rates, totals $139,000,000, excluding
pledged bonds. At 25, the entire issue sells for about 35 millions. The
bonds have a first lien on 6,000 miles of road out of a system total of 11,000
miles; they also are secured by equipment and other assets. Segregation
of earnings of the system (including the Terre Haute division) in accordance
with the various mortgage liens indicates that, after allowing for equipment-
trust charges, about 60% of the remaining earnings are applicable to this
issue. Hence, briefly stated, we see that a price of 25 for the general
mortgage bonds is equivalent to a total value of some 60 millions for all
properties of the St. Paul, subject to 29 millions of equipment obligations
valued by the market at par. (The junior liens not included in this total
would have at best a very small claim against the assets.)

This indicated value of about 90 millions for the St. Paul properties
compares with cost of reproduction less depreciation of no less than 660
millions; with total capitalization, at par, of 739 millions; with average
gross revenue in 1934-1938 of 99 millions; and average net available for
interest in those five years of about $8,100,000. If interest on equipment
trusts is deducted (as equivalent to an operating charge), the balance of
about $7,000,000 is equivalent to nearly 12% on the market price of the
various first-mortgage issues.

This summary view of the position of the General Mortgage bonds indi¬
cates that, unless the future prospects of the St. Paul are bleak , they must be
worth more than 25 cents on the dollar. How much more? Two methods
of appraisal are available, and for each we shall use the 1934-1938 average
as a measure of future earning power.

Method A. General Valuation , Independent of a Specific Reorganization Plan

We assume that net earnings of $8,000,000 will soundly support $4,000,-
000 of fixed charges, equivalent to 100 millions of first-mortgage 4% bonds
worth par. The balance of $4,000,000 of earnings may be capitalized
at 8%, to give $50,000,000 of equity junior to the first mortgage. This
results in a system value of 150 millions, or 120 millions above the equip-

808

SECURITY ANALYSIS

ment-trust issues. In turn, this means a value of 72 millions for the general
mortgage, or 52% of face value, as against a market price of 25.

This concise calculation is subject to the following questions and qualifica¬
tions:

1 . May the 8 million average net earnings properly be used as a measure
of future net? This figure is 2 millions more than was earned in 1938, but
it is about $1,400,000 less than the results for 1939. Estimates made in
January 1938 of “normal earnings” for the future set them as high as
$15,800,000. The results of the past decade have varied between 30 millions
in 1929 and less than 1 million in 1932. The maintenance ratio in 1934-
1938 was well above the average of other roads. On the whole, therefore,
the $8,000,000 estimate must be considered conservative, although the
future of railroad earnings is anything but certain.

2. Some of the value ascribed to the system must be allocated to junior
issues and thus deducted from the share of the general mortgage. Recent
reorganization technique indicates that this diversion of value will be
relatively small.

3 . More important is the question whether 8 millions of earnings will
justify 150 millions of market value in the manner we have calculated. A
crucial point here is the matter of future capital expenditures which may
have to be financed out of earnings, thus reducing the amount distributable
to security holders. Various reorganization plans have suggested that
between 2M and 5 millions be used annually for this purpose, after providing
4 millions for senior fixed charges. If this policy is followed, it is unlikely
that 8 millions of total earnings will result in a value of 50 millions for the
junior securities, since little if anything could be paid out in interest thereon.

Summarizing the foregoing, our appraisal may be found too liberal if large
provision for capital charges is necessary; on the other hand, it may well
prove to have been based on an unduly low estimate of future earnings.

Method B. Derived from a Specific Reorganization Plan

For this purpose we shall use the plan of readjustment proposed in Novem¬
ber 1938 by the I.C.C. Examiner, and seek to evaluate the new securities
allocated to the General Mortgage bonds. The plan provides $3,865,000
of fixed charges, based on present equipment trusts plus 77 millions of new
first 3Ms. Following is a deduction of between 2M and 5 millions (as
determined by the directors) for capital charges; then $3,600,000 income-
bond interest on Series A 4Ms; then $1,100,000 income-bond interest on
Series B 4Ms; after which comes a sinking fund and then the new preferred
and common.

The General Mortgage bonds are to receive about $350 each in new first
3Ms and Series A 4Ms and about $240 each in Series B 4Ms and preferred
stock. After seasoning, the 3Ms may deserve an ultimate market value
of 90. Earnings of 8 millions will nominally cover full interest on the
Series A 4Ms; but distribution will depend on the capital-fund appropria¬
tion. Market prices of, say, 40 for the Series A 4Ms» 20 for the Series B
4Ms, and 5 for the preferred seem reasonable, the last two representing

APPENDIX

809

mainly speculative possibilities. These would indicate a total value of 51
for the General Mortgage bonds, corresponding closely (as it should) with
the result reached by the first method. 1

Conclusion ,—The St. Paul General Mortgage bonds are clearly under¬
valued at 25 unless the future of the-railroads is so gloomy that practically
all carrier securities are currently overvalued. In any event, these bonds
should prove a better holding than the junior obligations and preferred
stocks of various Bolvent, but not strongly entrenched, railroads.

A COMPARISON OF MISSOURI, KANSAS & TEXAS AND ST. LOUIS-

SAN FRANCISCO

(Circular issued in January 1922)

Introduction.

The new securities of the Missouri, Kansas & Texas Railway present a
number of attractive opportunities for both the investor and the speculator.
The pending Reorganization Plan, which has recently been declared opera¬
tive, reduces the fixed charges of the system to a very conservative figure, so
that the bond interest should be regularly covered wuth a substantial mar¬
gin. Furthermore, the road’s excellent exhibit under current adverse
conditions gives promise of a substantial earning power available for the
junior securities.

The protracted receivership of the M. K. & T. will ultimately be found
to have strengthened the position of the new issues. For during this period
large expenditures were made for the physical rehabilitation of every part of
the system. The resulting improvement in roadway and equipment has in

Table I

St. Louis-San Francisco

Missouri, Kansas &
Texas

Rate,

Due

Price

about

Yield,

Rate,

Due

Price

about

Yield,

Prior lien bonds.

I960

69K

6.35

IISJ

6.35

1950

83K

6.25

6.50

1928

96H

6.55

1932

7.15

Adjustment bondst.

1955

73 H

8.16?

1967

11 . 11 *

Income bonds t.

Preferred stock.

Common stock.

(6)

1960

55H

21 H

10.81)

(7)

25M

* Assuming full interest paid,
t Straight yields given.

i The “Final Reorganisation Plan/’ issued by the I.C.C. in February, 1940, contains a
number of departures from the Examiner's plan, but the changes would not materially
affect the conclusion reached above.

810

SECURITY ANALYSIS

turn led to greater operating efficiency, so that its transportation costs
during the past year have been considerably lower than the average of
other roads.

In analyzing the value of the new M. K. & T. securities, it is inevitable
that comparison be made with the St. Louis-San Francisco. The two
systems are highly similar in location, character of traffic, and financial
structure. In fact the reorganization of Missouri, Kansas & Texas has been
closely patterned after that of the 'Frisco, which was consummated in 1916.

The similarity of capitalization of the two roads is illustrated by Table I,
(page 809), comparing the current price and yields of various issues:

In the following pages we discuss the general situation of the two com¬
panies, with respect to capitalization and operating results, and then present
a detailed comparison of the corresponding security issues. Our analysis
indicates that M. K. & T. will possess two underlying advantages over the
St. Louis-San Francisco:

I. Its fixed charges are lower in proportion to gross earnings.

II. Its operating efficiency is greater.

Through these important points of superiority, M. K. & T. should be
enabled to provide a larger degree of protection for its bonds, and a greater
relative earning power for its stocks. Basing our conclusions on a study of
the two systems, we recommend the following exchanges to holders of St.
Louis-San Francisco securities:

1. —From 'Frisco Prior Lien 4s, 5s and 6s into the corresponding M. K. &

T. Prior Lien issue, at their lower prices.

2. —from 'Frisco Income 6s at 55>£ into M.K. & T. Adjustment 5s at 45.

3. —From 'Frisco Common Stock at 21H into M. K. & T. Preferred Stock

at 25 y 2 .

Moreover, judging the M. K. & T. issues on their individual merits, we
regard the prior Lien Bonds as well-secured high yielding investments; and
the Adjustment Bonds, Preferred Stock and Common Stock as affording
attractive speculative opportunities.

The Missouri, Kansas & Texas and the St. Louis-San Francisco operate
chiefly in the same states and at many points are in close competition.

Hence the character of traffic of the two systems is fairly similar, except
that the 'Frisco carries considerably more coal and lumber and propor-

Table II.— Mileage Operated December 31, 1920

State

M. K. & T.

St. Louis-
San Francisco

Missouri.

544

1,720

Kansas.

487

626

Texas.

1,721

495

Oklahoma.

1,036

1,517

Other States.

898

Total.

3,807

5,256

APPENDIX

811

tionately less oil. The rates per mile for both freight and passenger business
are almost identical. M. K. & T. however averages a substantially heavier
train load and longer haul.

Table III.— Calendar Year 1920

Item

M. K. & T.

St. Louis-
San Francisco

Average revenue train load.

Average haul per revenue ton. ..

442 tons
248 miles

398 tons

187 miles

These two advantages no doubt account in good part for the much lower
transportation costs of the M. K. & T. in 1921.

Capitalization.

The security issues of the two companies will compare as follows:

Table IV. —Comparative Capitalization

Item

M. K. & T.

Frisco

Equipments and underlying issues
Prior lien bonds.

$ 7,248,000
93,073,000
57,500,000

$ 86,782,000
121,748,000
39,220,000
35,192,000
7,500,000
504,470 shares
(par $100)

Adjustment bonds.

Income bonds.

Preferred stock.

24,500,000

783,155 shares
(no par)

Common stock.

Fixed interest charges.

4,917,717

2,875,000

9,24S,374

4,750,912

Contingent interest charges.

Total interest charges.

$ 7,792,717

$ 13,999,286

The above figures for St. Louis-San Francisco arc taken from the last
available report, as of December 31st, 1920. Those for M. K. & T. are
based on the assumption that all the old securities are exchanged under the
provisions of the Reorganization Plan. It is probable, however, that some
of the present senior liens, especially the First 4s, due 1990, will still remain
outstanding. In such event, the amount of the underlying bonds, as
stated above, would be increased and that of Prior Lien issues decreased—
the aggregate remaining practically unchanged. The prospects are that
the fixed interest charges will actually amount to somewhat less than the
total given in the Plan, since the company will save of 1 % annually on
such of the $40,000,000 of 1st 4s as are not exchanged.

The “Contingent Interest Charges” represent the requirements of the
Income and Adjustment Bonds, which need be paid only if earned. This
elastic provision is a source of strength for both roads, as it will enable
them to reduce their interest payments in critical years without financial
disturbance.

812

SECURITY ANALYSIS

Table V.— Comparative Gross Earnings and Interest Charges per

Mile Operated

M. K

. &T.

'Frisco

Per mile

| % of gross

Per mile

% of gross

Gross earnings *.

$16,870

100.0

$16,730

100.0

Fixed interest.

1,300

7.7

1,790

10.7

Contingent interest.

760

4.5

920

5.5

Total interest.

$ 2,060

12.2

$ 2,710

16.2

* 1921 figure, December estimated.

Table V indicates the advantage that will be gained by M. K. & T.
through the drastic scaling down in its fixed interest charges. The latter
will require only 7.7c. out of each dollar of receipts, a ratio so low as to
guarantee a large margin of safety for the Prior Lien Bonds under ordinary
conditions. In this respect M. K. & T. is seen to enjoy an important advan¬
tage over St. Louis-San Francisco, its interest charges —both fixed and
contingent—being proportionately lower.

Earning Power.

In comparing the earning power of two enterprises, it is customary to take
the average of reports covering a number of years. In the present case,

Table VI. —Income Account Calendar Year 1921 (One Month

Estimated)

M. K. & T.

'Frisco

•

Income

% of
gross

Income

%of

gross

Mileage operated.

Gross revenues.

3,784

$63,842,000

100.0

6,165

$86,521,000

100.0

Maintenance.

24,635,000

38.6

26,874,000

31.1

Other operating expenses.

25,072,000

39.3

37,276,000

43.1

Taxes.

2,731,000

4.3

3,790,000

4.4

Rentals, etc., less other income

1,654,000

2.6

1,065,000*

1.2

Balance for interest.

9,750,000

15.2

17,517,000

20.2

Fixed interest.

4,918,000

7.7

9,248,000

10.7

Contingent interest.

2,875,000

4.5

4,750,000

5.5

Balance for stocks.

1,957,000

3.0

3,519,000

4.0

Pfd. div. requirements.

1,715,000

2.7

450,000

Balance for common.

242,000

0.3

3,069,000

3.6

• 1920 figures partly used.

APPENDIX

813

however, the disturbing influence of federal control makes such a procedure
impracticable. For the figures of earlier years are too remote, and those
from 1917 to 1920 are too abnormal, to afford a sound basis for analysis.
It is necessary, therefore, to lay chief emphasis upon the most recent operat¬
ing results. Statements for the eleven months ended November 30th,
1921 have just been published. By adding one-eleventh to these figures the
approximation to the full year’s income account may be shown in Table VI.

In analyzing the above figures, it is necessary to pay particular attention
to the much heavier expenditures for maintenance made by M. K. & T.
Out of each dollar of receipts, the latter road devoted 38.6c. to upkeep,
against only 31.1c. in the case of ’Frisco. It is well understood that the
amounts spent on maintenance are largely a matter of arbitrary determina¬
tion by the management and hence afford a method for more or less arti¬
ficially controlling the net earnings. As compared with other roads in the
same territory, it would seem that Frisco has been undermaintained and
M. K. & T. overmaintained during the past year. The result of this diverse
policy has been to make St. Louis-San Francisco's net earnings appear con¬
siderably larger and those of “Katy” considerably smaller, than on a
normal basis of upkeep expenditure.

If in the case of both roads the latter had been taken at 35% of gross—
apparently a reasonable figure—the net earnings of M. K. & T. would have
been $2,300,000 greater and those of ’Frisco $3,280,000 smaller than the
results actually reported.

How radically such a revision would affect the position of the various
securities is shown by the following analysis:

Table VII.— Earning Power 1921

Item

Actual results

Adjusted results (main¬
tenance ratio equalized
at 35%)

M. K. & T.

’Frisco

M. K. & T.

’Frisco

Fixed interest earned

1.94 times

1.89 times

2.51 times

1.54 times

Total interest earned

1.25 times

1.55 times

1.02 times

Earned on preferred

per share.. . .

$8.00

$46.92

$17.39

$3 19

Earned on common

per share.

0.30

6.08

3.25

Nil

The Prior Lien Bonds.

Although the M. K. & T. Prior Lien issue are selling several points lower
than the corresponding ’Frisco bonds, the above table shows that they are
better secured. For, despite the much heavier maintenance expenditure of
“Katy,” its fixed interest requirements were earned in 1921 with fully as

814

SECURITY ANALYSIS

large a margin. If proper allowance is made for the difference in upkeep,
then the superior showing of M. K. & T. becomes very marked.

The Income and Adjustment Bonds.

The interest on the M. K. & T. Adjustment 5s will be cumulative after
1925, while the St. Louis-San Francisco Income 6s are permanently non-
cumulative. During the next three years at least one-half of the income
available for the M. K. & T. Adjustments must be paid in interest. On the
base of the earnings of 1921, it is probable that the income bondholders will
receive the full 5% for this year.

These M. K. & T. and ’Frisco issues yield the same return, if full interest
is paid. The “Katy” bonds are closer to the rails, being directly junior to
the Prior Lien issues, while the ’Frisco Income 6s are subject also to the
Adjustment Mortgage. As indicated by Table VII, the M. K. & T. Adjust¬
ments should have the benefit of a considerably larger earning power under
normal operating conditions.

M. K. & T. 7% Preferred. (Cumulative after January 1, 1928)

Because of the similarity in market price, this issue is comparable with
’Frisco common rather than ’Frisco Preferred. M. K. & T. Preferred
makes an excellent exhibit in respect to current earnings, and appears not
only distinctly preferable to St. Louis-San Francisco common, but also an
independently attractive speculative purchase.

M. K. & T. Common.

While dividends on the issue are doubtless very remote, it should quickly
reflect marketwise any improvement in the general railroad situation or in
the position of Missouri, Kansas & Texas. At its present price of per
share, it possesses unusual speculative opportunities as a low priced railroad
issue.

A COMPARISON OF ATCHISON, SOUTHERN PACIFIC, AND
NEW YORK CENTRAL

(Circular issued in April 1922)

Introduction.

Recent weeks have witnessed a revival of interest in high-grade railroad
shares. This activity is of particular significance because it is based on
both investment and speculative considerations. The continued advance
in the bond list has first been followed by corresponding strength in the
preferred issues, and is now directing attention to the investment type of
common stocks—namely, those with long-established dividend records.

From the speculative standpoint also, railroad shares of the better class
are becoming increasingly attractive. Indications point clearly to a great
improvement in net earnings during 1922, as compared with 1921. Already
substantial increases in car loadings are being reported, and the improve¬
ment should be intensified by the industrial revival expected later in the

APPENDIX

815

year. Of even greater importance is the continued reduction of operating
expenses) which is gradually leading to a return of a normal ratio of net
earnings to gross receipts.

The high-grade railroad common stocks therefore deserve consideration
by both investor and speculator. We present herewith the results of an
examination of the present status and recent record of three of the prominent
issues of this type—Atchison, Southern Pacific, and New York Central.
Some of the most important data are summarized in the following brief table:

Common Stock

Road

Price

about

Divi¬

dend

rate,

Yield,

Earnings per share

Fixed

charges

earned

1921

Average

1914-1921

Atchison.

G .00

$14 GO

$12 89

4 00 times

Southern Pacific..

G G7

7.25*

8.35*

2.13* times

New York Central

■a

5.50

8.92

6.64

1.44 times

* Partly estimated. See text.

These figures indicate clearly the pre-eminence of Atchison from the
standpoint of earning power and financial strength. As compared with
New York Central, it shows a higher dividend return, larger earnings, and
a much smaller proportion of bonded debt. While Southern Pacific and
Atchison both pay 6% in dividends, Atchison has shown such pronounced
superiority in earning power as to justify fully its ten-point higher quotation.

In addition to its remarkable record of earnings the following features
in Atchison’s exhibit deserve special note:

1. Its wealth of cash assets.

2. Its valuable oil properties.

3. Its low and steadily decreasing funded debt.

The record of the three companies is analyzed in greater detail in the
following pages. Based upon a careful study of the available data, we sub¬
mit the following conclusions:

1. —That Atchison should be purchased at the present time, either as an
attractive investment or for conservative speculative profit.

2. —That Atchison is intrinsically more desirable than Southern Pacific,
because of its substantially greater earning power.

3. —That investment holdings of New York Central might well be
exchanged into Atchison, in order to obtain a higher dividend yield, larger
average earning power, and greater financial stability.

From the speculative standpoint, it is proper to point out that the small
amount of New York Central stock, in relation to its bonded debt and gross
revenues, may result in a more rapid increase in profits per share under
favorable conditions. Conversely, however, a relatively small decline in
net earnings can seriously reduce the balance available for the stock.

816

SECURITY ANALYSIS

Corporate Structure.

In analyzing the position of a railroad company, it is often necessary to
consider not only its own operations, but also those of subsidiary or affiliated
lines in which it has a substantial investment. Atchison and Southern
Pacific publish reports covering the results of the entire system, but New
York Central has large stock holdings in a number of important lines which
report their operations separately. The aggregate mileage of these con¬
trolled companies actually exceeds that of the New York Central proper.
Each year the subsidiaries carry a substantial amount to surplus, a good
part of which really accrues to New York Central stock, but is not reflected
in the parent company’s return. To afford a proper basis for judging the
value of New York Central shares, we shall analyze its earning power as
indicated both by its own statement and by a consolidated report embracing
all its subsidiaries. An added reason for using the latter method is found
in a recent statement that the New York Central intends to acquire the
outstanding minority shares of the controlled companies, in order to merge
their operations with its own.

The following table lists the separately operated subsidiaries of the New
York Central, together with their mileage and the percentage of stock held
within the system.

New York Central System

Company

Mileage

% of stock
owned

N. Y. Central R. R. .. .

Cincinnati Northern.

6,069

245

56.9

C. C. C. & St. Louis.

2,421

50.1

Indiana Harbor Belt.

120

60.0

Kanawha & Michigan. , .

176

100.0

Lake Erie & Western.

738

50.1

Michigan Central.

1,865

89.8

Pittsburgh & Lake Erie...

224

50.1

Toledo & Ohio Central...

492

100.0

Total system.

12,350

As regards Southern Pacific also, the exhibit of previous years must be
revised, in order to reflect the adjustments that have followed from the
recent segregation of the oil properties. Allowance is to be made for the
elimination of the former oil income, the exchange of convertible bonds into
stock and the receipt of $43,000,000 in cash through the sale of the Pacific
Oil shares.

Earning Power.

Particular interest attaches to the results during 1921 because they are
the most recent available and also because they represent the first full year

APPENDIX

817

Income Account 1921
(In Thousands of Dollars)

Item

Atchison

Southern

Pacific

N. Y.
Central

R. R.

N. Y.
Central
System

Mileage.

11,678

11,187

6,077

12,350

Gross revenue.

$228,925

$269,494

$322,538

$535,821

Net after rents.

41,268

39,823

56,679

Other income.

11,082

8,000*

15,665

Total income.

$ 52,350

$ 47,825

$ 72,344

$107,866

Fixed charges, etc.

13,018

■ m

50,048

71,519

Preferred dividends.

6,209

500

Applicable to minority

stock T .

4,302

Balance for common.

33,123

22,296

31,545

Per share.

14.69

7.25

8.91

12.62f

* Estimated. See text,
f Per Share N. Y. Central Stock.

Annual Earnings per Share op Common Stock 1914-1921

Southern

N. Y. Central

Calendar

AioniBon

Pacifio*

R. R.

System

B B

wm m

year

Guar-

Oper-

Guar-

Oper-

Guar-

anteed

ating

anteed

ating

anteed

wj&m

basis

151

basis

1921

■ ■

$ 7.25

$ 8.92

$12.62

1920

12 54

$13.98

1.89

$8.61

IB. 34(d)

$5.49

14.65(d)

$9.68

1919

15.41

16.55

7.03

8.40

6.23

7.97

10 73

8.62

1918

10.59

9.98

10 63

8.38

6.59

7.16

13.39

8.34

1917

13 96

10.24

13.25

1916

ifi aft

11.00

18.26

23.50

1915

BrSwIfll

8.90

11.08

13.80

1914

9.03

6.01t

4.10

3.69

Average:

Operating basis

$12.89

$8.33

$6.64

$ 9.54

Guaranteed

basis

.14

9.00

9.16

11.69

* See text,

t Year ended June 30.

818

SECURITY ANALYSIS

of independent operation. A summarized income account for 1921 appears
at top of page 817.

The fixed charges and non-operating income of Southern Pacific are esti¬
mated on the basis of the 1920 report, as adjusted to reflect the segregation
of the oil lands.

It will be seen at once that Atchison makes the best exhibit, not alone in
earnings per share, but especially in the small ratio of fixed charges to avail¬
able income. The combined income account of New York Central and its
subsidiaries indicates very substantial profits per share, but due consider¬
ation must be given here to the large proportion of its total capitalization
represented by bonds and rental agreements.

The conclusions indicated by the 1921 figures are confirmed by a con¬
sideration of the record of each company since 1914. We give the annual
earnings per share during this period, as shown at the bottom of page 817.
For 1918, 1919 and 1920, tw 7 o results are presented, based both on the actual
operations and on the government rental and guarantee. The Southern
Pacific figures are adjusted as indicated on page 817.

Not the least remarkable feature of the above exhibit is the regularity
with wrhich Atchison's net has been maintained at a high rate since 1915,
despite the unusual conditions affecting the carriers as a whole during a
good part of this period. The contrast with New York Central and South¬
ern Pacific is especially sharp in the transition year 1920.

Another significant feature is the substantial increase in Atchison's non¬
operating income, which rose from $4,311,000 in 1918 to $15,100,000 in
1919 and $9,842,000 in 1920. A good part of these profits was derived from
its oil properties, the importance of which seems to have been insufficiently
recognized.

Operating Statistics.

The superior earning power of Atchison as compared with both Southern
Pacific and New York Central, rests to some extent on a smaller capital¬
ization in relation to gross receipts, but more particularly upon lower
operating expenses. The appended table shows clearly the advantage
enjoyed by Atchison in the field of transportation costs:

Analysis of Operating Expense

Per cent of gross
receipts expended for:

Atchison

Southern Pacific

N. Y. Central
R. R.

1921

1918-

1913-

Maintenance.

36.9

38.7

36.0

39.6

30.1

34.1

33.9

45.0

34.3

45.1

25.4

38.8

31.9

46.1

36.3

47.6

29.9

40.0

Transportation, etc.

Total Operating
Expenses.. ,. .

75.6

64.2

78.9

79.4

64.2

77.0

83.9

69.9

APPENDIX

819

It will be observed that Atchison has been consistently liberal in its
maintenance expenditures. As compared with the similarly located South¬
ern Pacific, Atchison has regularly devoted a larger percentage of its revenues
to upkeep, and a much smaller percentage to transportation charges.

Capitalization Structure.

The proportion of stocks to bonds is largest for Atchison and least for
New York Central. The capitalization of the latter system appears rather
ill-balanced, so that relatively small changes in net income result in wide
fluctuations in the balance available for each share of stock. In prosperous
years this preponderance of bonded debt results in a large apparent earn¬
ing power for the stock, but in periods of depression it may constitute
a serious burden.

Securities Held by Public
(Thousands omitted)

Class

issue

Atchison
(Dec. 31,
'21)

%of

total

Southern
Pacific
(Jan. 14,
’21)

% of
total

N. Y.
Central
Railroad
(Dec. 31,
’20)

% of
total

N. Y.
Central
System
(Dec. 31,
*20)

%of

total

Bonds and guar¬
anteed stocks..
Preferred stocks.

$289,888

124,173

45.3

19.4

$473,644

57.9

$ 840,110*

77.1

$1,156,261*

9,998

74,302

249,597

77.5

0.9

Minority stocks.
Common stocks.

4.9

225,398

35.3

344,780

42.1

249,597

22.9

16.7

Total.

$639,459

$81S,424

$1,089,707

$1,490,158

100.0

* Includes Securities of Leased Companies, and 566,700,000 for cash lcntala capitalized
at 5%.

Conclusion.

The unique status of Atchison in the railroad field is perhaps best illus¬
trated by its treasury position. Despite the fact that the Company has
sold virtually no bonds during the past eight years, it held on December 31st
last over $52,700,000 in cash and government bonds, while its current
liabilities totalled $28,279,000.

The combination of large earning power and strong financial condition
justifies the expectation of an eventual increase in the dividend rate.

NOTE 67 (pages 149 and 700 of text)

The following is quoted from pages 594-5 t * { > of the 1934 edition of this work:

“A Current Example .—Fox Film Corporation, following large losses in
1931-1932, recapitalized as of April 1933 by persuading the holders of about
95% of its debt to take common stock in exchange therefor. As a result its
bank loans were eliminated and its note issue, due April 1936, was reduced
from $30,000,000 to less than $1,800,000. In December 1933 the 6% notes

820

SECURITY ANALYSIS

sold at 75, yielding over 20 % to maturity. The market value of the com¬
mon stock was about $35,000,000 and the net current assets were about
$10,000,000. The quantitative signs certainly pointed to the conclusion
that the note issue was amply protected, and cheap in consequence at 75.

“How dependable was this conclusion? It is certainly safe to say that
either the stock was not worth anywhere near $35,000,000 or else the
$1,800,000 note issue must be entirely safe. But a statement of this kind
is less conclusive than it sounds, because ordinarily there is no way of taking
advantage of a discrepancy between the relative prices of a highly speculative
stock and a senior issue of investment grade. 1 The analyst must decide
whether the issue is an attractive purchase, considered by itself. If the
business is highly unstable even an enormous junior equity might disappear
entirely and the note issue fail to be paid off despite its small size. In the
case of Fox Film we have on the one hand a large factor in an important
industry, which should argue for sufficient stability at least to assure dis¬
charge of this small obligation. On the other hand, the moving-picture
business has been highly speculative and the record of Fox Film since 1930
has not been confidence-inspiring.

“ Our conclusion must be, however, that the extraordinarily large quan¬
titative backing for these notes in December 1933 reduced the risk of non¬
payment to very minor proportions. Emphasizing once again the element
of diversification as a safeguard in all such operations, we express the view
that a number of purchases of this type will in all probability turn out
quite satisfactorily in the aggregate. That some losses will occur goes
without saying, but the proportion of such losses should undoubtedly be
much lower in a reasonably normal period such as 1923-1927 than in cata¬
clysmic years like 1930-1933.

Sequel .—The company covered its fixed charges nearly six times during
the balance of 1933, following the recapitalization. It covered its charges
nearly five times in 1934, nearly ten times in 1935 and over thirty-eight
times in 1936. The notes were paid off at par upon maturity on Apr. 4,1936.

NOTE 68 (page 712 of text)

MEMORANDUM FOR HOLDERS OF VICTORY BONDS

(Circular issued in May, 1921)

We desire to point out to owners of Victory 4%s, due June 1, 1923, the
advantage to be gained through their exchange at current prices into an
equivalent amount of Liberty Fourth 4J£s, due 1938.

At this writing the Victory 4%s are selling at about $97.70, and the
Liberty 4J£s at about $87.20. The straight income return on both issues is
the same—4.86%. Differently stated, each $400 of Victory notes can be
exchanged for $450 of Liberty Fourth 4Ks, on an even basis of both cost
and income return.

But the Liberty bonds have a great advantage over the Victory Notes
from the standpoint of prospective market appreciation. The possible

1 “In the Fox Film case, the 6 % notes were still exohangeable for stock on the basis of the
recapitalisation plan, i.e., at S1S.90 per share. If this were a contractual instead of merely
a voluntary conversion privilege, the Fox notes would have been demonstrably superior at
75 to the Fox stock at 14, from all atandpoinU."

APPENDIX

821

advance of the Victory Notes is strictly limited to two points, since their
near maturity (1923) precludes their selling at any considerable premium.
The Liberty bonds, however, are selling at so substantial a discount from
par (over 12^%), that it is not only possible but quite probable that there
will be an important advance during the next few years.

To use perhaps an extreme example, if wo suppose that by 1923 all
Victory and Liberty bonds have returned to par, the rise in the Fourth
Liberty bonds would amount to over twelve points against only two points
for the Victories. By making the proposed exchange, the investor would
then realize $450 for each $400 of Victory Notes now owned. In any event,
the Liberty 4J£s need to advance only two points in the next two years to
make the suggested exchange profitable.

In this connection we would point out that all indications favor an impend¬
ing advance in high grade bond prices. The tendency toward lower interest
rates is already apparent, as is evidenced by the reduction in the Federal
rediscount rate. For this reason, long term investments are now quite
generally preferred over short term notes, and consequently the income
return to be obtained on the former is considerably less than that on near
maturities. But in the case of the Victory issue, these short term notes can
be exchanged for long term Liberty bonds without any reduction in straight
income return.

Liquidation in the Liberty issues has been drastic and until recently con¬
tinuous, but this period now appears about ended. Bonds bought with
borrowed money have for the most part been paid for or sold; weak holdings
have been nearly eliminated, and the Liberty issues may now be regarded
as largely in the hands of real investors. This greatly improved technical
position should result in a substantial advance in price, in response to any
buying activity.

A further advantage to be gained from the proposed exchange lies in the
exemption of Liberty bonds (up to certain limits) from surtax as well as
normal tax; whereas, the Victory notes are exempt only from normal tax.

For these two important reasons—prospects of much greater price appreci¬
ation and superior tax exemption—we recommend that holdings of Victory
notes be now transferred into an equivalent amount of Liberty Fourth 4j^s.

We shall be glad to supply further information regarding this suggestion
and in particular to discuss with individual investors the current saving in
taxes to be gained from the exchange.

NOTE 69 (page 716 of text)

The principal tenets of the Dow theory are:

1. There are three types of fluctuations manifested by the averages:

а. Primary movements, which are broad basic trends of bull or bear
variety, extending over periods of less than a year to several years. Correct
determination of such movements is the major objective of Dow theorists.

б. Secondary movements } lasting from three weeks to several months but
running counter to the primary trend.

c. Day-to-day fluctuations in either direction, of minor character and of
slig ht significance except in determining whether or not “lines” are being

822

SECURITY ANALYSIS

formed. They must be charted and studied, however, since they make up
the longer term movements.

2. The industrial and railroad averages must corroborate each other if
reliable inferences are to be drawn concerning the nature of the movement
underway. Although, generally speaking, a bull market is one in which
succeeding highs in each average exceed the preceding highs, and successive
lows are higher than the preceding lows (and conversely for bear markets),
each type of major movement is subject to interruption by countermove¬
ments of a secondary character. These secondary movements are supposed
generally to retrace from a third to two-thirds of the primary price change
in the averages since the preceding secondary movement terminated. It is
apparent that the problem of determining from day to day or week to week
whether a movement apparently underway is a secondary one or a reversal
of a major trend presents a difficult task.

3. When movements of several weeks or longer are confined in both
averages to a range of about 5%, a “line” is said to have been formed sug¬
gesting either accumulation or distribution. If both averages break out
above the line simultaneously, accumulation is deduced therefrom, and
higher prices predicted. If the averages break out below the line simul¬
taneously, the reverse conclusions are deduced. If one average breaks
through a line without being confirmed by similar action by the other, the
indication is negative in character.

4. An overbought market becomes dull on rallies and active on declines;
and oversold markets are dull on declines and active on rallies. Large
volume characterizes termination of a bull market, and bull markets begin
with light trading.

5. Active stocks tend to move in consonance with the averages, but indi¬
vidual issues may reflect conditions peculiar to them which will cause
deviations from the pattern of the averages.

The foregoing statement of the main tenets of the Dow theory necessarily
does not indicate many important details or the practical manner of oper¬
ating under the theory. For more complete statements of the theory
and its applications see W. P. Hamilton, The Stock Market Barometer , New
York, 1922; Robert Rhea, The Dow Theory , New York, 1932; Charles A.
Dice, The Stock Market , pp. 486-506, New York, 1926; Floyd F. Burtchett,
Investments and Investment Policy , pp. 672-688, New York, 1938. On the
subject of chart reading generally, see R. W. Schabacker, Stock Market
Theory and Practice t pp. 591-692, New York, 1930.

NOTE 70 (page 721 of text)

“Investors Guide Stock Reports,” a department of Standard Statistics
Co., Inc., issued the following two bulletins in October and December 1933.

B (N.Y.S.E.)

Stock Rating

Common Hold II

$7 Preferred Hold, P.S.*

Warrants Hold II

* P. S. « Preferred-Speculative.

BALDWIN LOCOMOTIVE WORKS
Dividend Price Date Yield

None UH 12/21/33 None

None 34 % None

APPENDIX

823

COUNSEL: Constructive developments in sight serve to neutralize the
adverse effect in the COMMON of the eventual exercise of stock purchase
warrants. The PREFERRED has long term speculative attraction.
POSITION & PROSPECT: Although Baldwin’s operating expenses have
been held to a minimum, the lack of locomotive orders in 1933 is likely to
be reflected in another net loss for the year. Consolidated bookings have
recently exhibited moderate expansion and the 1934 outlook for the com¬
pany has been considerably improved by loans, which have been granted to
a number of roads by the PWA for the purchase of new equipment, including
30 locomotives. Applications are now pending from other carriers for
loans for equipment which will include 133 locomotives. Thus, there are
definite indications that a start has been made by the carriers to modernize
their tractive power, a program which is like ly to be in full swing later m
1934. Baldwin, with its strong trade position, may be expected to obtain
a goodly share of the business. While effective earnings on the common arc
still sometime off, especially since the stock is subject to considerable dilu¬
tion by the indicated eventual exercise of warrants attached to the con¬
solidated mortgage bonds permitting the purchase, at $5 of 480,000 addi¬
tional common shares, it appears that common per share losses should show
progressive abatement from now on. FINANCIAL POSITION is strong.
BACKGROUND: Baldwin Loco. Works is one of the two largest builders of
steam locomotives. It also manufactures forgings and castings, hydraulic
and special machinery, engines, air conditioning units, refrigeration equip¬
ment, etc. The company has a stock interest in General Steel Castings and
owns valuable Philadelphia real estate.

CAPITALIZATION: Funded debt, $15,500,000. 7% cum. pfd. ($100 par)
200,000 shares, red. at $125. Common (no par) 843,000 shares. Pre¬
ferred dividend accumulations total $17.50 per share at present.

Earnings

Dividends

Price

range

Com.

Pfd.

Com.

Pfd.

1933

Est. $5.S/ t (d)

Est. $15 50(d)

None

17 n- 3K

60 - 9H

1932

6.50(d)

SO 89(d)

None

12-2

35-8

1931

6.55(d)

20.61(d)

$3.50

27 %- A.%

104}f-15

1930

1.94

15.18

1.75

7.00

38 -19%

116 -84

Caution—This information has been obtained from sources believed to be
reliable but is not guaranteed.

BRY (N.Y.S.E.) BEATRICE CREAMERY CO.

Stock Rating Dividend Price Date Yield

Common Switch None \2% 10/17/33 None

$7 Preferred Switch $7 72 9.9%

COUNSEL: In view of near term uncertainties, holdings of the COMMON
and PREFERRED shares should be switched to issues with more promising
prospects.

824

SECURITY ANALYSIS

POSITION & PROSPECTS: Dairy operations remain under the handicap
of the industry's unfavorable statistical position. Milk production is well
in excess of consumption requirements, and this situation not only has
resulted in the building up of record sized stocks of butter and cheese but
also has prevented sustained price strength in these commodities. Price
advances on fluid milk, instigated mainly by state milk control boards or
AAA marketing agreements, nave been passed on almost entirely to farmers.
In addition, earnings of the company for the six months ended August 31,
last, were adversely affected by increased costs under the NRA and by
unsatisfactory ice cream sales during the peak months of July and August.
Share returns for the period amounted to $4.47 on the preferred and $0.28 on
the common, against $6.34 and $0.82, respectively, lor the like interval a
year earlier. Because of seasonal factors, an even smaller profit is indi¬
cated for the final half. Recovery promises to be slow until the excessive
milk supplies are eliminated. FINANCIAL POSITION is strong.
BACKGROUND: Beatrice is the third largest unit in the dairy products
industry. Formerly deriving the major portion of its earnings from butter,
the company in recent years has considerably expanded its activities in
ice cream and milk; in addition, it distributes cheese, eggs, and poultry.
Properties are located mainly in the Middle West, but extension into eastern
and Pacific Coast markets also has been effected.

CAPITALIZATION: Funded debt. none. 7% cum. preferred ($100 par)
107,851 shares. Common ($25 par) 377,719 shares.

Earnings*

Dividends!

Price range!

Com.

Pfd.

Com.

pfd.

Com.

Pfd.

1933

SO. 84(d)

$ 4.03

None

27-7

85 - 46

1932

3.54

19.30

$2.50

43^-lOK

95 - 62

1931

7.12

32.49

4.00

81 -37

111 - 90

1930

7.31

34.02

4.00

92 -62

109H-101M

* Years ended February 28.
t Calendar years.

£ Continuance possible.

Caution—This information has been obtained from sources believed to be
reliable but is not guaranteed.

INVESTOR'S GUIDE STOCK REPORTS

(Copyrighted and Published by Standard Statistics Co., Inc..

345 Hudson St., N.Y.)

Oub Discussion in the 1934 Edition

It is evident that the advice to hold Baldwin Locomotive and to sell
Beatrice Creamery shares was based predominantly upon the view that the
prospects of the locomotive business were good and those of the dairy
industry were poor. With respect to the former it is implied that the
improvement will continue for a number of years; in the case of Beatrice
Creamery it is not clear whether the statement that “ recovery promises to
be slow” presages a delay of months or of years.

APPENDIX

825

The approach of the securities analyst towards these two common issues,
if based upon the principles and technique developed in this book, would be
quite different from—in fact, almost the direct opposite of—that indicated
in the “Stock Reports” given above. The analyst's initial reasoning as to
Beatrice Creamery would run somewhat as follows: “Current conditions
are known to be unfavorable and the near-term prospects are generally
considered unfavorable also. The price of the stock has declined substan¬
tially. Is it possible that the shares may have intrinsic or permanent
value considerably in excess of the current low price, which is governed
by the current situation?”

In the case of Baldwin Locomotive, his reasoning might well run in the
contrary direction:

“The company’s prospects are decidedly better for 1934 than they were
for 1933 and 1932. However, the stock is selling at five times the low price
of 1932. Are these prospects favorable enough and dependable enough to
make the common stock attractive at its current price, in view of the very
unsatisfactory record for the past ten years?”

In developing the answer to these questions a statistical analysis some¬
what along the following lines would be in order. (These data are not pre¬
sented as a “comparison” of Baldwin and Beatrice in the ordinary sense,
but rather as an aid in arriving at separate analytical conclusions in respect
to each issue.)

Item

Baldwin Locomotive

Beatrice Creamery

A. Capitalization:

Bonds at par.

S15.500.000

Preferred stock at
market.

7,000,000

$ 7,750,000

Total senior issues..

$22,500,000

7,750,000

Common stock at
market.

9,400,000

4.700,000

Warrants at market

3,400,000

Total common-stock
issues.

12,800,000

Total capitalization

35,300,000

12,450,000

B. Recent Income Ac¬
count:

12 mo. ended Sept. 1933

12 mo. ended Aug. 1933

Sales.

7.730,000

44,045,000

Net before depreci¬
ation and interest

1,000,000(d)

1,831,000

Depreciation.

1,850,000

1,605,000

Interest.

1,160,000

Preferred dividend
requirement.

1,400,000

750,000

Balance for common

6 , 410 , 000 (d)

5*4, OOO(d)

826

SECURITY ANALYSIS

C . Earnings Record (000 omitted):*

* Baldwin: Year ended Sept. 30, 1933, and calendar years preceding. Figures are on a
comparable basis, except those for 1925. Figures for 1925-1928 are corrected to
reflect the average depreciation of $1,022,000 per annum, as discussed in Chap.
XXXIV. Earnings on total capital for 1928 are approximate.

Beatrice: 1933 means year ended Aug. 31, 1933. 1932 means year ended Feb. 28, 1933,

and similarly for 1925-1931. Profit of $389,000 on sale of securities made by Beatrice
in 1928 is excluded.

D. Results for 11 Normal Period” 1925-1930:

Average earnings for total capitalization of Baldwin

Locomotive works.about $2,900,000

Average earnings for common stock and warrants of

Baldwin. 824,000

Average earnings per share of Baldwin common (assum¬
ing warrants exercised and 6 % earned on the amount

received by the company). $ 0.73

Maximum earnings per share of Baldwin common (as

adjusted). $ 3.17

Average earnings per share of Beatrice common. $ 6.59

Maximum earnings per share of Beatrice common.$ 7.31

Note: owing to the continuous expansion of Beatrice Creamery between
1925 and 1932, involving the issuance of additional shares, the earnings
per share of common must be considered as more significant than the
amounts earned for the common stock as a whole.

E. Balance Sheet Figures (Dec. 31, 1932):

APPENDIX

827

Note: Baldwin’s working capital figures are adjusted to exclude the
interest of the Midvale Company minority stockholders. The asset
value of Baldwin common is adjusted on the assumption that the
warrants are exercised. The asset value of Beatrice common has
not been adjusted for a write-down of fixed assets in 1033, the amount
of which had not been reported.

A study of these quantitative exhibits yields no reason to believe that
Baldwin Locomotive common stock is intrinsically attractive at about $11
per share. The only markedly favorable items are the earnings of the
single year 1926, and the book value; but neither of these may be con¬
sidered particularly significant. Superficially, the issue appears to possess
a factor of “leverage,” or speculative capitalization structure, based upon
the presence of a large amount of senior securities. In fact, however, this
leverage could become of real value only if the profits exceeded any figure
realized since 1926.

In the case of Beatrice Creamery the statistical showing is impressive
on two important counts. The first is the consistently large earnings per
share in the six years 1925-1930, amounting regularly to almost 50% on
the current price of 12%. The second is the very large sales of the enter¬
prise per dollar of common stock at market. Even at the low prices of
dairy products in 1933 there were nine dollars of sales for each dollar of
common stock. In 1929 the ratio was about eighteen to one. Manifestly
there is need of only a very small profit per dollar of business done to yield
a large percentage of earnings on the present price of the stock.

Certain other analytical features of the Beatrice exhibit are of interest,
viz.:

1. The capitalization structure gives the common stock especially favor¬
able speculative possibilities from the technical point of view. All of the
relatively large senior capital is represented by preferred stock, which carries
no danger of financial embarrassment.

2 . The large tangible asset value in relation to the market price is not
without significance. While this point must not be taken too seriously, it
has a bearing on the question whether the company is likely to earn a
reasonable amount on the common shares over the long future. Although
a write-down of the fixed assets was in contemplation, this conclusion would
hold also on the revised basis.

3. Assuming the write-down to be justified, it would imply that the
depreciation charges in recent years had been larger than necessary. In
the year ended February 1934, the depreciation charge was reduced to
about $1,400,000, compared with $1,900,000 in the previous year. Had
this rate applied for the 12 months ended February 1933, the company
would have shown some earnings for its common stock in that year.

4. The working capital position is strong for this type of enterprise, and
in relation to the market price of its shares.

Qualitative Considerations.

A . Baldwin Locomotive: It would appear difficult to form any dependable
conclusion as to the long-term prospects, or the normal earning power, of
this enterprise. The industry is a basic one, and the exceedingly low rate

828

SECURITY ANALYSIS

of locomotive buying for some years past would undoubtedly point to a
large accumulated demand. Nevertheless, the business has shown itself
to be erratic in the extreme, and views as to its future performance must
be more in the nature of conjecture than intelligent prediction.

B. Beatrice Creamery: The business of this company would seem to
possess an underlying stability as well as permanence. The demand for
dairy products is certainly not subject to the variations existing in the
demand for locomotives. While periods of oversupply may affect selling
prices drastically, the resultant difficulties are not more serious than are
found in countless other lines of business. There is reason to believe that
the dairy industry will grow over the long future as it has in the long past.
The recession of demand during 192$-1933 was a natural phenomenon of
deep depression, and it would hardly appear to hold ominous significance
for the years to come. Beatrice Creamery is not so favorably situated as
the two larger companies (Borden's and National Dairy Products), which
enjoy greater diversification and a profitable business in trade-marked
brands. Yet the probabilities would point strongly to a recovery of the
earning power of Beatrice Creamery to somewhere near its former well-
established level, when general conditions are once again propitious.

An individual prediction of this kind may go astray, for to some extent it
must be at the mercy of the future. But it is our view that conclusions
based upon this type of reasoning will yield more profitable results—on the
average and over the long pull—than the type of “market counsel” repre¬
sented by the bulletins quoted at the beginning of this final note. 1

Sequel

Conditions developed for both companies very much as the analyst
might have anticipated (though not prophesied) at the end of 1933. In
the case of Baldwin, despite the supposed better outlook the loss for 1934
was practically the same as in 1933, and deficits were reported each year
until 1939. In 1935 the company entered 77B proceedings, and the price
of the common fell to 1H* At the end of 1939 it was selling at the equiva¬
lent of 3 in terms of the new securities received in reorganization.

Beatrice Creamery reported a profit for its common stock in the year
ended February 1935. Its earnings expanded steadily thereafter (with the
exception of one year) until they reached $3.81 per share of common for the
12 months ended November 1939. At the close of that year the stock was
selling at 27^.

NOTE 71 (pages 333 and 367 of text)

The thesis of Mead and Grodinsky may be summarized in the following
paragraph:

All industries decline eventually, after expanding for a longer or shorter
period. Once decline’begins, it is rarely reversed* At any one moment, all

* Our criticism of certain individual methods followed by Standard Statistics Company,
Inc., should not be construed as reflecting upon the work of this outstanding organization
in general. On the contrary, it deserves high praise for the acouracy and completeness of
its reporting and for the enterprise and open-mindedness it has always shown in developing
its scope and technique.

APPENDIX

829

industries may be divided into those expanding and those declining. The
onset of decay may be detected by the following symptoms: stationary
demand, resort to betterments instead of to additions, endeavors to advance
prices and the borrowing of money. Sound investment must be strictly
confined to expanding industries and preferably to companies showing
progressive qualities through research activities. It must necessarily
include common stocks, since the supply of bonds and preferred stocks in
such groups is very limited. To allow for future retrogression, the investor
must set up amortization reserves out of his income and principal
profits.

That this point of view reflects important truths underlying corporate
affairs and investment experience cannot be denied. But whether—in the
form stated or any approximation thereto—it supplies a sound and practi¬
cable pattern of investment is quite a different question. Some implications
of this thesis may be noted:

1. Investments in growing industries and switches out of declining indus¬
tries are to be made regardless of current prices. If a large percentage of
stock owners followed this principle, the price of “good” stocks would
advance sensationally, whereas unpromising stocks would fall to almost
nothing—regardless of their earnings and assets. Neglect of the price
factor in this theory must reflect the belief either that the price makes no
difference or that, on the average, investors do not in fact have to pay too
high a differential for good stocks. The first alternative is clearly untenable;
the second is more than doubtful. The behavior of the market in the past
decade already betrays the influence of this philosophy in the heavy pre¬
miums being paid for growth stocks. Its further extension might work
havoc.

2 . The method prescribed is not nearly so simple as it sounds, except on
the side of avoidance. The investment accepted must meet both industry
tests and a number of requirements applicable to the individual company;
the holder must then be alert for the inevitable signs of impending decay and
be ready to sell in spite of satisfactory earnings or—conversely—of an
unsatisfactory market level.

This general method involves the dilemma that either the number of
eligible growth industries is so restricted that any large concentration of
investment therein becomes thoroughly impracticable, or else a generous
bestowal of the accolade will result in many mistakes or prompt reversals.
Mead and Grodinsky have had the courage to divide all industries into the
expanding or the contracting category—listing 61 of the former and 60 of the
latter. Certainly there must be many borderline cases; in fact we should
imagine that a very large middle group would fall into the indecisive bracket
and that confident statement would be restricted to, say, the top and
bottom quartiles.

More serious is the possibility that growth will cease without adequate
warning and before the investor can reap his reward. A striking tendency
for trend to revise itself is found by comparing changes in the net earnings
of industrial groups from 1926 to 1930 (or 1928-1930) with the further
change to 1936. Data for such a study may be found in the Mead and

830

SECURITY ANALYSIS

Grodinski tables or in the Standard Statistics Company’s compilations of
net earnings of industrial groups for 1926 onward.

3. The counsel to avoid bonds of declining industries in favor of stocks of
expanding industries, given in amazingly categorical fashion, 1 may be
objected to on additional grounds. The counselors are themselves at pains
to point out (pages 461-462) that the sinking-fund device may retire the senior
capital of nonexpanding enterprises before they are engulfed in the ultimate
and inevitable collapse. Furthermore, to guard against the same tragic
fate that awaits even the growing company—but after a longer interval—
Mead and Grodinsky insist (pages 465-467) that the investor in its common
stock must set up his own sinking fund out of dividends received or profits
taken, so that only part thereof is really income. We should think that the
bonds of Swift & Co. (in a “declining industry”) deserve to be called safe,
for obvious quantitative reasons, even allowing for a reduced per capita
consumption of meat in the future. But how the common stock of Johns
Manville—a leading issue in an “expanding industry”—can be called
“safe,” regardless of whether the investor bought at 155 in 1937 or 58 in
1938, passes our understanding.

4. The elaborate studies on which Mead and Grodinsky base tlicir
principle of investment suggest other conclusions which should be of great
value to stockholders. It may well be true that in many cases the onset of
decline presages the complete loss of earning power and the almost complete
loss of stockholders' equity and that management, however competent and
resourceful, is powerless to prevent the debacle. But if this is so, the
owners of the business may have other alternatives than merely to sell their
shares in the open market for whatever they will fetch. Would not exactly
the same reasoning, which seeks to persuade the individual holder to sell his
stock, be more logically employed to persuade all the stockholders to realize
on their assets before they are dissipated?

We consider that The Ebb and Flow of Investment Values carries a powerful
argument in support of our own thesis (developed in Chaps. XLIII and
XLIV), viz.y that the persistence of market price below liquidating value is a
signal that clamors to be heeded; that it challenges the stockholders to find
out whether their interest requires the business to continue as before, to
change its policies, to be sold or to be partially or completely liquidated; and
that, finally, the answer to this crucial question should be sought not from
the management—with its prejudices and special interests—but from a
competent and impartial outside agency.

1 “The record and the present situation show that, as far as safety is concerned, the com¬
mon stocks of the successful corporations of the expanding-industry groups which do not
issue bonds are safer than the bonds of the successful corporations in the declining-industry
groups." The Ebb and Flow of Investment Values, p. 298, New York, 1939.

INDEX

Abbott Laboratories, 9, 14
Acceleration clauses, 236
Accounting, artifices, 24
methods, 53

rules and standards of, 447
“Accounting: Its Principles and Prob¬
lems,” 465n
Acid test, 612
Acme Steel Co., 453n
Adams, E. S., 166
Adams Millis Co., 538
Adjustment bonds (see Income bonds)
Advance-Rumely Corp , 709n
Adventure Company, Ltd., The, 57n
Advertising expenses, 424, 427, 429
Aeolian Co., 205n, 250
Aeronautical Corp. of America, 639, 654
Affiliated companies (see Subsidiaries)
Affiliated Fund, Inc., 255, 305n
Agricultural-implement companies, 48, 54
Aircraft flotations, 657
Airplane issues, 525n, 556, 652, 693
(see also Aviation)

Air Reduction, 365
Ajax Rubber Co., 337
Alabama Gas Co., 172n
Alaska Juneau Gold Mining Co., 47, 457,
52 In

Alleghany Corp., 256, 650n, 660
Allied Chemical & Dye Corp., 51n, 456n,
636

Allied Owners Corp., 209n
Allis-Chalmers Mfg. Co., 365, 709n
Allotment ccitificates, 72, 314n
Amalgamated Laundries, Inc., 701
American Airlines, Inc., 538
American Arch Co., 51, 497
American Austin Car Co., 654
American Bantam Car Corp., 654
American Book Co., 49n
American Can Co., 2, 51, 346-349, 390,
392n, 396, 451, 453, 626
American Car &, Foundry Co., 206n, 449,
452

American Cigarette A Cigar Co., 566n
American Commercial Alcohol Corp., 503,
618

American Electric Power Corp., 313, 467
American European Securities Co., 255

American & Foreign Power Co., 72, 319, 321,
474, 639, 642, 644, 664 -666, 710
American Founders Trust Co., 6C2
American Gas & Electric Co., 87, 88, 394n,
474

American Glue Co., 604
American Hide & Leather Co., 341
American Home Products Co., 14
American Ice Co., 446
American Laundry Machinery Co., 498, 514,
543n, 592, 687

American Light & Traction Co., 397, 667
American Locker Co., 636
American Locomotive Co., 447, 516n
American Machine & Foundry Co., 97n,
252

American Machine & Metals, Inc., 414, 416
American Maize Products Co., 549-551
American Metal Co., 261, 422
American Power & Light Co., 394n, 471,
474, 639

American Rolling Mill Co., 617
American Safety Razor Co., 536
American Seating Co., 337
American Smelting & Refining Co., 422, 626
American Snuff Co., 191
American Steel Foundries, 51, 452
American Sugar Refining Co., 97n, 373, 449,
452

American Sumatra Tobacco Corp., 50n
American Telegraph & Cable Co., 216
American Telephone & Telegraph Co., 3, 33,
54, 74, 174, 309n, 310, 316, 609n, 667
American Terminals & Transit Co., 70n
American Tobacco Co., 191, 207n, 224, 257,
301, 436, 456, 566, 598
American Type Founders Co., 226
American Water Works and Electric Co.,
47, 394n, 471-474, 478, 538, 547, 709
American Woolen Co., 627
American Zinc, Lead & Smelting Co., 203n,
339-341, 543n
Amortization, 445-464
investor’s viewpoint of, 479-601
of bond discount, 426
of good-will, 463
of mining companies, 456
of oil companies, 456
of oil reserves, 496
of ore reserves, 493

831

832

SECURITY ANALYSIS

Amortization, of patents, 463, 497
(see also Depreciation)

Anaconda Copper Mining Co., 311,312,457.
614

Anacostia A Potomao R.R., 215
Analysis, comparative, 669-684
descriptive, 18
investment and, 348
procedure of, 684
speculation and, 27-30

(see alio Securities, analysis of)

Analyst, future and, 349
««. speculator, 42, 687
Analyst’s investment, 66, 68
“Analyzing the Stock Market,” 715n
Ann Arbor R.R., 441n
Annual reports, 48
Antidilution clauses, 308
Anthracite carriers, 165
Apartment houses, financing of, 141, 142
Applications, listing (see Listing applica¬
tions)

Appraisal (s), 139, 148

of common stock, by analyst, 531-537
current earnings as basis of, 510
by securities market, 402, 684
Arbitrage, 24, 63, 324n, 722
Archer-Daniels-Midland Co., 612, 618
Argentina, government bonds, 112
Armament orders, 12
Armour of Delaware, 226
Armour and Co. of Illinois, 226, 413
Arm’s-length dealing, 651
Articles of incorporation, 46, 235
Ashland Home Telephone Co., 252n
Assets, capital, sales of, 407
cash, 579
value of, 572
current, 181

value of, 572, 685, 690
significance of, 578-610
fixed, 574, 579
sales of, 406

write-downs of, 459, 489-493
intangible, 51
tangible, 351, 379
values, 12, 337, 352, 353, 358, 567
wasting, 257

Associated Gas A Electrio Co., 72, 210n, 314,
426, 474

Associated Oil Co., 97n
Association of American Railroads, 163n
Atchison Topeka A Santa F6 Ry., 86, 206n,
209, 213, 298, 305n, 316,. 346, 373, 375,
384, 436n, 437, 674
Atlantic Coast Line, 436
Atlas Corp., 644

Atlas and Digest of Railroad Mortgages, 157»
Atlas Tack Co., 694n

Auburn Automobile Co., 393n, 394n
Audit, independent, 429
Austin Nichols A Co., 204, 262
Australia, government bonds, 112
Austria, government bonds, 112
Automobile-development expense, 424
Automobile manufacturers, 44, 54, 682
Average, deficits included in, 515
significance of, 506

s«. trend of earnings, 41, 359, 511-513
Averaging of earnings, 9, 671, 686
Aviation industry, 12, 40
Axe, E. W., & Co., 3
Axe-Houghton indexes, 3
Ayres, Col. Leonard P., 718

Babson, Roger, 606

Badger, R. E., and H. G. Guthmann, 123n,
200n

Bagehot, Walter, 79
Baking companies, 14, 682
Balance sheet, 51
analysis of, 567-634
check on income account, 429
vs. income account, 402, 582, 619-627
long-term comparison, 618-634
significance of, 678
usefulness of, 567

Baldwin Locomotive Works, 47, 324n, 449-
451, 627, 640, 643

Baltimore & Ohio R.R., 245, 251, 278n
Bangor & Aroostook R.R., 115, 358, 693
Bankers, commercial, 280
investment, 281, 651-653

compensation of, 651, 653-656
Banking Board of New York State, 109,
117n

Bank(8), debt, intermediate, 618
loans, 626

dividends affected by, 615
railroads and, 614
stocks, 61, 62, 411
Bankruptcy, 236n, 353
Bankruptcy Act (see Chandler Act)

Bargain issues, 282, 589, 691, 698
Barker Bros. Corp., 556
Barnhart Bros. A Spindler Co., 226
Barnsdall Oil Co., 443, 639, 645
Barron's Magazine, 715n
Bayuk Cigars, 266
Belding, Heminway Co., 336
Belgium, government bonds, 111, 112
Bemis Brothers’ Bag Co., 49n
Bendix Aviation Corp., 415
Benesch, I., A Sons, 586n, 604

INDEX

833

Berkey 6c Gay hurmou*e Co., 260, 337, 647n,
761

Berle, A. A., Jr., A G. C. Means, 205n, 399n,
695

Bethlehem Steel Co., 301, 389, 453, 616n,
698, 697, 707

Better Business Bureau, 280n
Bills payable, 614
Blanket mortgage, 251
Blanket prohibitions, 108
Blast-furnace test, 718
Bloomberg, L. N., 677n
Blue-chip issues, 62, 356, 530, 535
Blue-sky flotations, 280, 651, 656
Blumenthal, Sidney, A Co., 233, 263, 336
Boeing Airplane Co., 693
Bolivia, government bonds, 112
Bon Ami Co., 50n
Bondholders, voting by, 241
Bond(s), called, discount and premium on,
426n

convertible, 33, 71

(see also Convertible issues)
defaulted, 185
discount, 424

amortization of, 426
financing of, 98, 99
forecasting prices of, 282
foreign, 108, 110-113
form, 59, 69

high-grade, scarcity of, 108
income (see Income bonds)
industrial (see Industrials, bonds)
investment in, 4, 59
insurance factor in, 102
logic of, 78
investment-trust, 254
low-priced, 330-333
vs. notes, 83
pattern of, 71

vs. preferred stocks, 185, 242, 334
prices, future of, 5
range of, 184
public-utility, 91, 94, 95
railroad, 4, 94-96
retirement of, premium on, 413
vs. stocks, 59

low-priced, 330, 333
of subsidiaries, 231-234
trading in, 282, 687
underlying, 88, 251
unsecured (see Debentures)
yields, 2, 14

Book values, 21, 147, 351, 353
computation of, 667-577
exaggeration of, 664
of preferred stock, 570
significance of, 673-677
Borg, Warner, Corp., 448
Borrowing of stock, 328

Bosland, C. C., 357n
Boston A Maine B.R., 124n
Botany Worsted Mills, 422
Bowker Building, 140n
Braunthal, Alfred, 459n
Brazil, government bonds, 112
Break-up value, 664
Brewery stocks, 519, 652
flotations, 657n
British Companies Act, 383n
Biooklyn Heights R.R., 215
Brooklyu-Manhattan Transit System, 35,
154, 615

Brooklyn A Queens Transit Corp., 264
Brooiuyn Rapid Transit System, 215, 627
Brooklyn Union Elevated R.R., 35, 82, 215,
701

Brooklyn Union Gas Co., 317, 325, 467-469,
471, 474

Brown Shoe Co., 191
Brunswick-Balke-Collender Co., 264
Budd Manufacturing Co., 253n
Budd Wheel Co., 322
Buehler, A. G., 388n
Buildings, depreciation on, 486
location of, 143
special-purpose, 140
Bulgaria, government bonds, 112
Burchill Act, 239n

Bureau of Business Research of the Uni¬
versity of Michigan, 194
Burtchett, F. F., 200n
Bush Terminal Building Co., 413
Business, analysis of, 38
cycle, 95, 363
expansion of, 597
index, 2
merger of, 583

nature of (see Character of enterprise)
reasoning, 574
sale of, 583—586
valuations, 574

Business man’s investment, 104, 332
“Business and Modern Society,” 621»
Busses, vs. railroads, 166
transportation by, 40

Butte A Superior Mining Co., 525, 692,
693

Byers, A. M., Co., 262n
C

(Viable feature, 71
Callable provisions, 303-306
Called bonds, discount and premium on,
426n

Calumet A Hecla Consolidated Copper Co.,
521

Canada, bonds, 127

government, 111, 112

834

SECURITY ANALYSIS

Canadian Pacific Ry., 95n, 219
Canadian trust indentures, 242
Can companies, 39, 516
Capital Administration Co., 271, 569
Capital, assets, sales of, 407
expenditures, 50
invested, 12, 13
earnings from, 577
return of, 602
stated, 269

structure of, 403, 672-674, 677
speculative, 667

Capital, working, 181-183, 252, 263, 335-
338, 537, 611-616, 620
Capital-goods industries, 1C6
41 Capital Income Debentures,” 72
Capitalisation, changes in, 537-540
coverage of, 149
of fixed charges, 179-181
overconservative, 544
reduction of, 270
speculative, 557
structure of, 541-553
optimum, 543
speculative, 547-553
Capitalizing, of earnings, 686
Carbon-black companies, 171
Carloadings, 718
reports of, 47

Case, J. I., Co., 21, 23, 68, 507
Cash assets, 579
value, 572

Cash holdings, 182, 611
Caterpillar Tractor Co., 47n
Celanese Corporation of America, 50n, 51,
304, 322

Celluloid Corp., 304, 322
Cement industry, 681

‘‘Census of American Listed Corporations,”
181n

Census of Manufactures, 56
Central Branch Union Pacific Ry., 89
Central Leather Co., 270, 273, 627
Central R.R. of New Jersey, 106n, 443
Central States Electric Corp., 255, 302, 308,
313, 319, 390, 397, 636, 662, 709n
Central Steel Co., 120n
Centrifugal Pipe Corp., 498
Century Ribbon Mills, Inc., 334, 335
Cerro de Pasco Copper Corp., 457
Certificate of Incorporation, 235
Chain stores, 12, 14, 38, 47, 229, 424n, 463,
530, 682
taxes and, 688
Chamberlain, Lawrence, 59n
Champion Paper & Fibre Co., 193n
Chance, element of, 29
Chandler Act, 83n, 214n, 236n, 238-248,
801

Character of enterprise, 83-37, 39-40, 91,
107-113, 560
Character of traffic, 165
Chart reading, 714-718
Charter, 46
Chemical shares, 12

Chesapeake Corp., 308, 317, 543, 660, 709n
Chesapeake <fc Ohio Ry., 95n, 161, 165,
166n, 180, 288, 291, 440, 453, 660, 709n
Chicago, Burlington & Quincy R. R., 95n,
437, 439

Chicago & Eastern Illinois R. R., 88, 205n
Chicago, Great Western R. R., 54, 161, 710
Chicago Herald & Examiner, 83n
Chicago, Milwaukee, St. Paul «& Pacific
R. R., 169, 209n, 215, 249, 314n, 322
Chicago & North Western Ry., 89, 136, 168,
208n, 257n

Chicago, Rock Island & Pacific Ry., 168n,
616, 660, 673, 699

Chicago, Terre Haute & South Eastern Ry.,
209n, 215

Chicago Yellow Cab Co., 358, 453n
Chile Copper Co., 651n
Chile, government bonds, 112
China, government bonds, 112
Choctaw & Memphis R. R., 699
Chrysler, 546n
Churches, financing of, 141
Cigar companies, 39, 402, 516
Cigar-machinery patents, 500
Cigarette companies, 39, 48, 402
Cigarettes, consumption of, 516
Cincinnati Gas & Electric Co., 471
Cities Service Co., 170, 393n, 394n, 465, 615,
646n

Cities Service Power & Light Co., 172, 175,
176, 466n

City Ice & Fuel Co., 264
Classification of enterprises, 92
Classification of securities, 73-76
Cluett Peabody & Co., 380n
Coal companies, 39, 94, 96, 681
Coal roads, 681

Coca-Cola Co., 9, 365, 391, 517, 534, 570,
691

Cold-storage companies, 170
Collateral-trust bonds, 136-138
Collins & Aikman Corp., 50n
Colombia, government bonds, 112
Colorado Fuel & Iron Co., 151, 199, 209,
616, 640, 710

Colorado Industrial Co., 616, 710
Columbia Gas & Electric Corp., 399n,
426n, 474

Commercial and Financial Chronide, The,
55, 685

Commercial bankers, 280
Commercial Credit Co., 365

INDEX

835

Commercial Investment Trust Corp., 285»,
307, 310n, 618, 637n, 642
Commercial Mackay Corp., 241n, 319
Commercial Solvents Co., 492, 674, 576
Commodities, prices of, 614
Commonizing senior issues, 339, 342
“Common Stock Indexes,” 357 n, 561 n
“Common Stock as Long-term Invest¬
ments,” 357

Common stock (s), analysis of, history, 344-
349

merits, 343

appraisal of, by analyst, 531-537
dividend factor in, 372
flotations of, 652
guaranteed, 74
investment in, 8-16, 343-371
investment valuations of, 531-537
low-priced, 554-559
pattern, 71

va. preferred stock, 335
interest, 187

price-earnings ratios for, 630-540
price range of, 184
shoe-string, 552

speculative valuation of, 533-536
of subsidiaries, 179

“Common Stock Theory of Investment,
The," 357n

Commonwealth Edison Co., 288, 291, 470,
474

Commonwealth & Southern Corp., 201, 474,
639

Companies’ Creditors Arrangement Act,
Canada, 239n

Comparative analysis, 669-684
Comparison, of related issues, 709
of senior issues, 707-709
Compensation, of investment bankers, 651,
653-656

of management, 596, 651
Competition, 13, 349, 360, 512, 518, 577
Competition, busses and trucks vs. railroad,
166

governmental, 40, 94, 561, 675
Component, speculative, 67
Composition, 244
Concealment of data, 24
Congolcum Co., 699
Congress Cigar Co., 311
Consolidated Cigar Corp., 638
Consolidated Edison Co., 51, 435n, 472-474
of New York, 474

Consolidated Film Industries, Inc., 322
Consolidated Gas Co., 51, 435n
of Baltimore, 474
of New York, 191
Consolidated Oil Corp., 459n, 650

Consolidated reports, 177, 232, 435-444
Consolidated Textile Corp., 309n
Consolidated Traction Co. of New Jersey,
233

Consolidation (see Mergers)

Construction cost, 140
Continental Baking Co., 514, 667
Continental Can Co., 48, 193n, 394n
Continental Gas & Electric Corp., 191n
Continental Motors Corp., 557n
Continental Oil Co., 460
Continental Steel Corp., 252, 678- 680
Contingency reserves, 467, 479 505
Control, 659, 667
value of, 368

Controlled companies (see Subsidiaries)
Conversion, level, 299
parity, 299
price, 299

privilege, as compensation for risk, 286
closeness of, 299
delayed, 316
duration of, 299
at option of company, 314
Convertible issues, 33, 71, 284-329, 553
allowance for, 538
debenture certificates, 314n
opportunities in, 293
profit possibilities of, 287
sold at initial premium, 316
vs. warrant-bearing issues, 302
Copeland, H. II., and Son, 158n
Copper companies, 47, 456, 525, 559
Corn Products Refining Co., 97n, 191, 207n,
627, 632-634

Corporate policies (see Management)

Corporate profits, 11

Corporate reports, 685

Corporations, investment by, 726

Cosmetics companies, 519

Cost of production, 559

Costa Rica, government bonds, 112

Cotton-goods industry, 39, 40, 422, 681

Coty, Inc., 519

Coupon rates, 132

effect of, on safety, 545
high, 103-104, 122
Court-Livingston Corp., 70n
Covenants, protective, 235-260
Cowles, A., 3d, et al., 357n, 561 n
Cram's Auto Service, 52
Crown-Zellerbach Corp., 320
Crucible Steel Co., 152, 153, 387
Cuba, government bonds, 112
Cudahy Packing Co., 85, 453n
Cumulative-deductions method, 127
Current assets, 13, 181
values. 148, 572, 678, 685, 690
significance of, 578-610
Current earnings, as basis of appraisal, 5l0

836

8ECVRITY ANALYSIS

Current ratio, 611
Curtis Publishing Co., 705n
Cushman’s Sons, Inc., 442
Cyclical risks, 102
Cyclical swings, 685

Csecho-Slovakia, government bonds, 112
D

Dairy companies, 682
Data, concealment of, 24
Davis Coal & Coke Co., 563n, 566n, 587
Dawson Ry. & Coal Co., 315n
Debentures. 83, 84, 109, 116, 118, 126, 137,
261

v». mortgage bonds, 210
Debt, effective, 180, 672
funded, 100, 197
unsecured, 261
maturing, 616-618
Deed of trust ( see Indentures)

Default, 81. 82, 94, 236
of bonds, 185

event of, 236, 237n, 253, 259
Deferred charges, 423-426, 668n
Deferred maintenance, 163n
Deficits, treatment of. 515
De Lavaud process, 498
Delaware & Hudson R.R., 214
Delaware, Lackawanna & Western R.R.,
166n, 563

Denmark, government bonds, 111, 112
Depletion, 49, 63, 52In
charges, 456
(see also Depreciation)

Depreciation, 49, 61, 53, 155, 270, 438,
445-664, 675, 677
base, 446-448
on buildings, 486-488
concealment of, 453-456
definition for public utilities, 473
equivalent to fixed charge, 550
expended. 483-485, 487, 491
inadequate, 488-493
omission of, 171
of publio utilities, 465-479
rate of, 448-453
of real estate, 143
straight-line, 469, 473, 476
tax return vs. income-account basis, 472-
478

(see also Amortisation)

Depression, 5, 12, 41, 91-101, 129, 155, 279,
355, 615

recovery from, 333
Descriptive analysis, 18
Detachable warrants, 320
Detroit, City of, bonds, 122t»

Detroit City Gas Co., 474
Detroit Edison Co., 466, 471, 474, 477

Detroit United Ry., 698
Development expenses, 424
Dewing, A. 8., 124n, 194n, 225n, 643n, 695n
Department stores, 40, 48, 229, 682
Dilution clauses, 308
Directors, 378
(see also Management)

Discrepancies between price and value, 20,
22

Distilling Co. of America, 215
Diversification, 63, 336, 353, 355, 362
of traffic, 158, 165
Dividend (a), accruals of, 339
vs. earnings, 381
effect of bank loans on, 615
changes of, 694
factor, 351, 372-400
omission of, 186, 188, 606
optional, 387
participations, 72
payments, prohibition of, 253
policies, 374-388, 597, 602, 606-608
American vs. foreign, 379
court interference with, 378
stockholders’ approval of, 382
taxation and, 378, 386-388
rate, 352
ratio, 381

record of, 107, 123-125
scrip, 646
special, 439

stability vs. amount, 375
stock, 694

effect on cash dividends, 392
extraordinary, 389-396
periodic, 393-400
preferred, 398
pyramiding by, 397
valuation of, 662
subsidiaries’, 178, 672
withholding of, 186, 374-380, 559
yield of, 381
Divisional liens, 89
Dixon, Joseph, Crucible Corp., 49n
Dodge Bros., Inc., 310n, 646n
“Dollars behind Steel,’’ 57n
Dollars-per-share formula, 201
Dome Mines, Ltd., 457
Domestic & Foreign Investors, 255
“Dominion Companies Act, 1934, Tha,”
239n

Dominican Republic, government bonds,
112

Douglas Aircraft Co., 612
Dow Chemical Co., 365
Dow, Jones & Co., 52
Dow-Jones Industrial Average, 2, 10, 14,
686

“Dow Theory, The,” 714, 715n
Downs, L. A., 163n

INDEX

837

Drilling costs, 458
Drug, Inc., 232
Drug manufacturers, 682
Dun & Bradstreet Corp., 49n
Du Pont, E. I., de Nemours & Co., 193*,
264n, 365, 415, 437
Duquesne Light Co., 191, 471, 474
Dwellings, financing of, 142
valuation of, 139

Earning power, 147, 401, 405, 513
concept of, 506
intrinsic value and, 21
long-range study of, 627-634
stability of, 98
Earning(s), average, 9
averaging of, 671, 686
capitalizing of, 686
coverage, 125-133, 196, 199, 251
current, as basis of appraisal, 510
distortion of, 439-441
va. dividends, 381
from invested capital, 577
nonrecurrent, 529
per-share, 438
emphasis on, 417
price ratios, 9, 530-540
pyramiding of, 434
(aee also Pyramiding)
ratio of, 128, 381
record, 351

significance of, 352, 506-520
retention of, 377

trend of, 349, 352, 353, 358, 511-514, 583
®s. average, 359

undistributed, of subsidiaries, 164
war, 633
yield, 381

Eastman Kodak Co., 191, 203
"Ebb and Flow of Investment Values,
The," 333*, 367n
Effective debt, 180, 672
Effective par value, 570
Eitingon-Schild Co., 261
Electric Bond & Share, 3, 598, 664-666
Electric and gas companies, 352
(see also Public utilities)

Electric Power & Light Corp., 358, 474,
637, 643, 644
Electric refrigeration, 40
Electric Refrigeration Building Corp.,
836

Electric Refrigeration Corp. (Kelvin&tor),
335, 699

Electric Storage Battery Co., 449
Elmira & Williamsport R. R., 209n
El Paso & Southwestern R. R., 315n

Ely & Walker Dry Goods Co., 589
Engineers Public Service Co., 312n, 474
Enterprise (s), character of, 33-37, 39-40,
560

classification of, 02
new, 651, 656, 725
security flotations by, 556
popularity of, 679
retail, 227

size of, 13, 107, 113-116
Equal-and-ratable security clause, 249
Equipment, hire of, 159
obligations, 134-136, 258
Equity, 567
trading on, 552

Erie R. R., 166n, 205n, 241 n, 439, 453, 640,
646 661

Esthonia, government bonds, 112
Eureka Pipe Line Co., 482-484
Event of default, 236, 237n, 253, 259
"Everyman and His Common Stocks,” 60n
Exculpatory clause, 246
Expended depreciation, 483-485, 487, 491
Expansion, 597, 599
unwise, 378, 383, 387

Extraordinary items (see Nonrecurrent
items)

Extraordinary losses, 416-423
(see also Nonrecunent losses)

Fabricanfc, Solomon, 446n

Factor of safety, 128n

Factory buildings, financing of, 141

Fairbanks, Morse <fc Co., 130, 151, 252

Falconbridgo Nickel Co., 709n

Famous Players Canadian Corp., Ltd., 127

Farm (aee Agricultural)

Faultless Rubber Co., 605*

Federal Communications Commission, 54,
174n

Federal Housing Administration, 142n
Federal Knitting Mills, 604
Federal Land Bank bonds, 218
Federal Light & Traction Co., 394n
Federal Mining & Smelting Co., 257
Federal Power Commission, 470, 473, 477n
Federal Reserve Board, 13
Federal Revenue Act, 421n, 592, 598*
Federal taxes, deduction of, 176
Federal Trade Commission, 53
Federal Water Service Corp., 179
Fertilizer companies, 39, 48
Fifth Avenue Bus Securities Co., 62
Financial Investing Co., 138
"Financial Policy of Corporations,” 194n
"Financial Study of the Joint Stook Land
Banks,” 218n

838

SECURITY ANALYSIS

Financing, cost of, 648-658
of investment trusts, 51, 648
Finland, government bonds, 112
Fire-insurance companies, 410
Firestone Tire & Rubber Co., 601, 603
First National Stores, 43, 44
Fisk Rubber Co., 85, 118, 243, 262, 616, 700
Fitch services, 18, 54
Five-and-ten-cent stores, 682
Fixed assets, 574, 579
sales of, 406

write-downs of, 270, 450, 489-493
Fixed charges, calculation of, 227-232
capitalization of, 179-181
coverage {see Earnings, coverage)
depreciation equivalent to, 550
Fixed-value investments, 73
selection of, 77-105
Florence Stove Co., 691
Florida East Coast Ry., 136
Flush production, 457
Forecasting, 15, 371, 713-722
of bond prices, 282
Foreclosure, 81, 237

Foreign Bondholders’ Protective Council
Inc., 113n

Foreign bonds, 108, 110-113
Foreign-exchange items, 409
Foreign trade, 111
Form 10-K, 49, 658
Foulke, R. A., 61 In
Fourth National Investors Corp., 640
Fox Film Corp., 149n, 244, 700n, 706, 819
Fox New England Theatres, Inc., 83n
France, government bonds, 111
Franchises, 160, 567
Fraudulent securities, 70
Freeport Sulphur Co., 305, 523
Freeport Texas Co., 305, 305n
“Freight Traffic Density Charts,” 158n, 168
French, Fred F., Co., 34n
French Plan, 34n
Fritzemeier, L. H., 554n
Fuel-oil consumption, 166
Fuels, railroad, 165-169
consumption of, 167
Fuller, George A., Co., 205n
Funded debt, 100, 197

Future developments and prospects, 5, 13,
25, 39, 42, 63, 66, 332, 349, 362, 370,
533, 537, 561, 679, 689
analyst and, 349
near-term, 721

Gabriel Co., The, 519n
Garages, financing of, 141, 144
Garfinckel, Julius, & Co., 652n
Gartley, H. M., 715n

Gas companies (see Public utilities)

Gas & Electrio Securities Co., 394n
Gas Securities Co., 647n
General American Investors Co., 255, 273n
General Baking Co., 43, 97n, 156, 182n
General Cigar Co., 83n
General Electric Co., 2, 9-11, 63, 64, 67, 68,
97, 191, 192, 198, 205, 207n, 390, 394n,
497, 530, 534, 574, 627
General Foods Co., 193n, 251n
General Motors Acceptance Corp., 97n
General Motors Corp., 47, 386, 409, 437
438, 667, 687

General Public Service Corp., 255
General Securities Corp., 661
General Shoe Co., 652n, 682n, 691
General Steel Castings Corp., 447
“General Theory of Employment, The,”
392n

Geneva Corp., 661

Geographical differences, in railroad analy¬
sis, 163n

Geographical distribution, 356
Georgia Midland Ry., 224
German bonds, llO/i, 112
Gilchrist Co., 557n
Gillette Safety Razor Co., 497
Gilt-edged securities, 274
Gimbel Bros., 415, 558
Glen Alden Coal Co., 563, 566
Glenn L. Martin Co., 693
Glenwood Range Co., 49n
Going-concern value, 147
Gold, price of, 526n
stocks, 652
Gold Dust Corp., 425
Goodbody & Co., 477n
Goodman Manufacturing Co., 49n
•Good-will, 51, 379, 577
amortization of, 463
Goodyear Tire Rubber Co., 413, 418
Gotham Silk Hosiery Co., 251n
Governmental competition, 40, 94, 561,
675

Goodrich, B. F., 252, 413, 626

Graham, Benjamin, 240n, 388n

Granby Consolidated Mining Co., 457

Granite City Steel Co., 678-680

Grant, W. T.. Co., 231

Great Atlantic & Pacific Tea Co., 37, 688

Great Britain, government bonds, 111, 112

Great Northern Ry., 72, 437

Great Western Power Co., 315»

Greece, government bonds, 112
Green Bay & Western R.R., 209, 322
Green River Valley Terminal Co., 70n
Griess-Pfleger Tanning Co., 72
Grocery companies, 44, 682
Gross uusiness, 114-116
Ground rent, 143

INDEX

839

Group purchases, 362, 686
Growth, 371
companies, 364-367
stocks, 725

Guaranteed issues, 213-227
common stocks, 74
Guarantees, joint and several, 217
Guardian Investors Corp., 255n
Guatemala, government bonds, 112
Gulf Oil Corp., 415, 459
Gulf States Steel Co., 96, 413
Guthmann, II. G., and R. E. Badger, 123n,
200n

Hahn Department Stores, 264
Haiti, government bonds, 112
Hall Printing Co., 448
Hamilton Gas Co., 171n
Hamilton Woolen Co., 584, G03, 605
Handbook of Commercial and Financial
Services, 56 n

Harbison-Walker Refractories Co., 51, 452n
Hard-coal railroads, 166
Harriman Building, 259n
Hartman Corporation, 52, 399
Harvard Business Review, 194n
Harvard School of Business Administra¬
tion, 194

Hatfield, II. R., 465n
Haul, length of, 168
Havana Electric Ry., 637n
Haytian Corp., 238n
Hazel-Atlas Glass Co., 51
Hazel tine Corp., 499
Hecker Products, 425
Hedging, 24, 63, 326-329, 694, 709, 722
Helme, G. W., 191
Hercules Powder Co., 436
Heterogeneous industries, 682
High-cost producers, 560
Ilillhouse, A. M., 123n
Hillside Coal & Iron Co., 439
Hiram Walker-Goderham & Worts Co., 311,
312

nire of equipment, 159
Hocking Valley Ry., 453, 661
Hoe, R., & Co., 337
Holding companies, 234, 434, 659-668
public-utility, 89, 92, 176
railroad, 668

Holland, government bonds, 111, 112
Holmes, J. H., <fc Co., 555n
Homestake Mining Co., 457, 493-496
Homogeneous industries, 681
Hosiery manufacturers, silk, 40
Hosmer, W. A., 620n
Hospitals, financing of, 141

Hotels, bonds, 487
financing of, 141, 144
Howard Aircraft Corp., 639
"How to Evaluate Financial Statements,’ 1
611n

Hudson Motor Car Co., 507
Humble Oil & Refining Co., 97n
Hungary, government bonds, 112
Hupp Motor Car Corp., 588
Huyler’s of Delaware, 226

I.C.C. ( see Interstate Commerce Commis¬
sion)

Ice companies, 94, 170, 174
Idle-plant expense, 422, 441
Illinois Central R. R., 203n, 437
Illinois Iowa Power Co., 474
Illinois Power & Light Corp., 474
Illinois Zuic Corp., 404n
Income vs. safety, 592
sources of, 560-560
tax(es), 49

check on, 429, 432

law, 456

liability, 190

(see also Federal taxes)

Income account, 49, 401

va. balance sheets, 402, 582, 619-627
vs. surplus, 403, 417

Income bonds, 71, 114, 118, 128, 151, 208-
213, 671

margin of safety for, 210
vs. preferred stocks, 210
return (see Yield)

Incorporation, articles of, 46
certificate of, 235

Indenture(s), 46, 54, 208. 235, 239, 260, 271
minima, 466

provisions (see Protective covenants)
trustees, 240, 245-248
Independent Oil & Gas Co., 302
Indiana Harbor Belt Ry., 231
Industrial companies, 436
reports, 47-51
Industrial financing, 705
Industrial Ofiice Building Co., 245n
Industrial plant, 138
Industrial Rayon Co., 242n
Industrial (s), 100, 101, 197
bonds, 9G, 97, 109, 115, 116, 128, 156,
259, 705

financing of, 84n, 544
sound, shortage of, 544
comparisons, 675-683
preferred issues, 192
stock prices, 2
Inertia of investor, 704
Inflation, 8, 94, 142, 726

840

SECURITY ANALYSIS

Inflation of inventory, 625-627
Information, sources of, 46-56
Ingeraoll-Rand Co., 191
Inland Steel Co., 152, 153, 18 8
44 Insiders,” 602n
Insolvency, 237-248, 578, 616
effect on price, 701
prices in, 242
(see also Trusteeship)

Instability, 92, 345, 361, 383
Institutional investment, 726
Insull pyramid, 615, 659n
Insurance companies, fire, 410
life. 415

Insurance factor in bond investment, 102-
103

Insurance securities, 410
Intangible assets, 51, 380, 431, 577
importance of, 345
write-offs of, 270
Intangible drilling costs, 458-461
Interborough Rapid Transit Co., 19, 23,
81n, 257, 259, 315, 526, 711
Interborough-Metropolitan Corp., 270, 526
Intercontinental Rubber Products Co., 297
Intercorporate indebtedness, 616
Interest, coverage (see Earnings, coverage)
payment record of, 121-123
pure, 101, 103
rates, 14, 131-133
future of, 5

Intermediate bank debt, 618
International Business Machine Corp.,
97n, 365

International Cigar Machinery Co., 500
International Hydro-Electric System, 313,
474

International Nickel Co. of Canada, Ltd.,
365, 457

International Paper Co., 262
International Paper & Power Co., 273n,
312n

International Securities Corp. of America,
413, 662

International Shoe Co., 691
International Telephone & Telegraph Co.,
425

Interstate Commerce Commission, 37, 52,
54, 157, 163n, 164, 239n, 245n, 247,
257n, 439, 453n, 486, 562n, 661, 700
Interstate Department Stores, 75n, 228,
273n, 320, 424n
Interstate Hosiery Mills, 404n
Intertype Corp., 516
Intrinsic value, 19-27, 68, 624, 721
(see also Value)

Intuition vs. judgment, 516
Inventory(ies), 60, 579, 614
accounting, 418-422
inflation of, 625-627

Inventory losses, 416, 622-627
reserves for, 418-420, 504
normal stock method, 505
Invested capital, 12, 13
earnings on, 577

Investment Bankers Association of America,
172n

44 Investment Principles and Practices, ,f
200n

Investment (s), advioe regarding, 280-283
analysis and, 346
analyst's, 66, 68
bankers, 98, 281, 651-653, 658
compensation of, 651, 653-656
companies, 137
in bonds, 4

insurance factor in, 102
logic of, 78
business, 60, 67
business man’s, 104, 332
certificates, 314n
in common stocks, 8-16
component, 67
by corporations, 726
counsel, 282
financial, 66

fixed-value (see Fixed-value investments)

institutional, 726

legal, 106-147, 192, 440

permanent, 4, 274

policy, problems of, 1-16

price factor in, 355, 366

private-business test of, 368, 370

safety in, 63

sheltered, 66

short-term, 60, 726

size of, 726

®«. speculation, 57-68, 354, 392, 545, 725
straight, 74

supervision of 274-283
timing of, 369

trusts, 9, 57, 60. 236, 355-357, 371, 412,
570 n, 690
bonds, 156, 254
financing of, 648, 651
statements of, 409
types of, 66
value, 68

of common stock, 531-537
44 Investment and Speculation,” 59n
44 Investments and Investment Policy,” 200n
“Investment Value of Goodwill, The,” 677n
Investor, inertia of, 704
of large means, 725
of small means, 8, 722-725
vs. speculator, 15-16
Iowa Public Service Co., 467
Ireland, government bonds, 112
Iron Steamboat Co., 258
Island Creek Coal Co., 191, 202, 205, 669

INDEX

841

Island Oil & Transport Co., 697
Issuing houses, 268

(see also Investment bankers)

Italy, government bonds, 112

Japan, government bonds, 112
Johns-Manville Co., 534
Joint-facility rents, 159
Joint and several guarantees, 217
Joint Stock Land Banks, 218
Jones <fe Laughlin Steel Co., 510n
Jordan, D. F., 719n
Journals, trade, 50
Judgment vs. intuition, 516
Jugoslavia, government bonds, 112
Junior capital, maintenance of, 269-273
Junior vs. senior issues, 84-88, 143, 709

Kanawha & Hocking Coil & Coke Co , 214
Kansas City Power & Light Co., 191, 474
Kansas City Public Service Co., 244
Kansas City Southern Ry. t 204n, 6G1
Kansas City Terminal Ry„ 217
Kaufmann Department Stores, 264, 492
Kaufmann Department Stores Securities
Corp., 543n

Keith-Albee-Orpheum Corp., 327

Kelly-Spnngfield Tire Co., 270

Kelsey-Hayes Wheel Co., 304

Kelvinator Corp., 336, 699

Kendall Co., 262n

Kennecott Copper Corp., 457

Keynes, J. M., 391n

Kinney, G. R., Co., 253n, 313

Koppers Co., 272

Koshland case, 39In

Kraft Cheese Co., 425

Kress, S. H., & Co., 202, 228, 399, 507

Kreuger, Ivar, 404

Kreuger & Toll Co., 75, 305, 322

Lackawanna Securities Co., 563, 566

Lackawanna Steel Co., 627

Lake Erie & Western R.R., 660

Lambert Co., 14

Land values, 357

Last-in first-out method, 421

Law of diminishing returns, 360, 512

Lawyers Mortgage Co., 142, 221

Lawrence Portland Cement Co., 335

Leading «a. secondary companies, 12-14

Leased lines, 159, 160

LeaseCs), obligations, 227-231
oil, 458, 462
(see also Rentals)

Leasehold(s), 462
appreciation of, 430
improvements, 462
obligations, 223-225
Leather companies, 39
Lee Tire & Rubber Co., 682n
Legal investments, 106-147, 192, 440
Leggett, F. H., Co., 335
Lehigh Coal <k Navigation Co., 443, 566n
Lehigh Valley Coal Co., 119, 120
Lehigh Valley R.R., 166n, 245
Leverage, 547-553
Lexington Utilities Co., 271
Libbey-Owens-Ford Co., 365
Liens, divisional, 89

prior, prohibition of, 249
(see also Mortgage lien)

Life insurance policies, 414
Liggett, Louis K., Co., 232
Liggett & Myers Tobacco Co., 97n, 191, 201,
278, 301

Light and power companies (see Public
utilities)

Lighthall, W. S., 239n
Lima Telephone Co., 174
Lincoln Motor Co., 651n
Liquid assets (see Current assets)
Liquidating value, 12, 148n, 578-610, 624
Liquidation, 24, 570n, 583, 586, 699-601,
604, 701

Liquor issues, 14, 652
flotations of, 556, 657
Listing applications, 46, 52, 448
Litigation, 695-698

items, accounting of, 415
Loading charge, 639
Location of enterprise, 107, 110-113
Loews, Inc., 209n, 230, 320, 638
“Lombard Street,” 79
Lone Star Gas Co., 83n
Long-term vs. short-term issues, 315
Loose-Wiles Biscuit Co., 51, 193n, 262n
Lorillard, P., Co., 97n
Loss(cs), avoidance of, 79
extraordinary, 416-423
inventory, 622-627
nonrecurrent, 416-423

(see also Nonrccurrent items)
of subsidiaries, 441
Louisville & Nashville R.R., 436
Low grade senior issues, 330-342
Low-priced stocks, 554—559
Lumber companies, 39
Lyman Mills, 604
Lyon, Hastings, 123n

842

SECURITY ANALYSIS

Machinery companies, 682
Mack Trucks, Ino., 516n
Mackay Companies, 52
Macy, R. H., & Co., 393n, 394n
"Main Street and Wall Street,” 172n
Maine, legal investments in, 127n
Maintenance, 50, 672
deferred, 163n
of equipment, 163
of public utilities, 471, 473-474
railroad, 162-165, 167
ratio, 163
of way, 163

Mallinson, H. R„ & Co., 621
Management, 38, 40, 349, 410, 433, 533,
599, 609, 679
compensation of, 651, 658
competence of, 596
cost of, 648-658
market price and, 601
obligations of, 608
policies of, 374-378, 582, 594-610
Management vs. stockholders, 388, 595
Manati Sugar Co., 644
Mandel Bros., 558

Manhattan Shirt Co., 588, 623-625, 627
Manhattan Electrical Supply Co., 407, 414
Manhattan Ry., 528
Manipulated accounting, 427-435
Manipulation, 21, 662, 694n
of earnings, 439-441
“Manual of Investments,” 128n
Maple Leaf Milling Co., Ltd., 241n
Margin, element, 10

of safety, 96, 97, 128n, 278, 71G, 720
for income bonds, 210
Margin-of-safety principle, 368
Marginal trading, 10, 59, 686
Marion Steam Shovel Co., 337
Mark-downs of fixed assets, 270, 459, 489-'
493

Market, activity of, 679

analysis vs. peourity analysis, 713-722
appraisals by, 684
behavior of, 25
conditions, 155
cycles, 511
irrationality of, 510
leadership, 688
price, intrinsic value and, 26
effect of scarcity on, 301
management’s interest in, 601
signals, technical, 15
technical study of, 715-718, 722
trading in, 371
turn of, 28

value, of securities, 148, 409-412
Marketability, 25, 116, 368, 601

Marland Oil Co., 458
Marlin Rockwell Corp., 50n
Martin, Glenn L., Co., 693
Maryland Casualty Co., 223n
Mason City & Fort Dodge R.R., 54
Mathieson Alkali Works, 50n
Maturing debt, 616-618
Maturities, serial, 258
Maturity date, 118-120
May Department Stores, 492
Maytag Co., 266-268, 543n, 667
McCrory Stores Corp., 230
McKeesport Tin Plate Corp., 453n
McKesson & Robbins, Inc., 264, 337, 404n
McLellan Stores Co., 230
Mead, E. S., and J. Grodinski, 333n, 367
Means, G. C , and A. A. Berle, Jr., 205n
Meat-packing companies, 39, 682
Mergers of business, 583, 695
Mcrritt-Chapman & Scott Corp., 644
Mesta Machine Co., 50n
Metals industry, 681
Metropolitan Casualty Co., 223n
Mexico, government bonds, 112
Michigan Consolidated Gas Co., 474
Middle West Utilities Co., 398u
Midland Steel Products Co., 449
"Milking” of real estate, 142
Milwaukee, Lake Shore & Western R.R.,
208n

Milwaukee, Sparta & Northwestern R.R.,
89

Mine(s), 532
life of, 496

Mining companies, 448
amortization of, 456
analysis of, 521-526
.stocks of, 59

flotations of, 556

Minority interests, in subsidiary common
stock, 179

Minneapolis, St. Paul & Saulte St. Marie
R.R., 216, 232

Missouri, Kansas-Tcxas Ry., 82, 211-213,
313

Missouri Pacific R.R., 89, 205n, 661
Mobile & Ohio R.R., 227n, 241n
“Modern Coiporation and Private Prop¬
erty, The,” 205n, 399n, 595
Mohawk Hudson Power Corp., 302, 320
Mohawk Mining Co., 586, G04
Mohawk Rubber Co., 551
Money rates, 718

Monsanto Chemical Co., 193n, 365
Montana Power Co., 540
Montecatini, 320
Montgomery Ward A Co., 272
“Moody’s Manual of Investments, 34n, 54,
128n. 44 In. 61 In

INDEX

843

Moratorium, 129 n, 259n
Mortgage Guarantee Co., 221
Mortgage, blanket, 251
bonds vs. debentures, 210
guaranteed real-estate, 220-223
lien, 80-90, 116
purchase-money, 250
Motion-picture companies, 39
Mouquin, Inc., 653n
Moving expenses, 424
Mullins Manufacturing Corp., 47, 692
Municipal bonds, 114-116, 121-123, 156
Municipal financing, 258
Murphy, G. C., 193n
Murray Corp., 336

Nairn Linoleum Co., 699
National Acme Co., 271, 337
National Biscuit Co., 77, 191, 258 348,
392n, 396, 454

National Bondholders Corp., 697n
National Broadcasting Co., 464
National Cloak & Suit Corp., 380n
National Department Stores, 204
National Distillers Products Corp., 304
National Enameling & Stamping Co., 453n
National Fund, Inc., 639
National Hotel of Cuba, 241n
National Investors Corp., 364
National Lead Co., 421
National Power & Light Co., 474
National Radiator Corp., 250n, 646n
National Sugar Refining Co., 97n, 452
National Surety Co., 223
National Trade Journals, Inc., 289-921
National Transit Co., 408
Natural-gas companies, 53, 94, 170
Neisner Bros., Inc., 231
Neisner Realty Corp., 231
Net deductions, 160, 162, 180
Net worth, 350, 353
Netherlands, government bonds, 111
Neutrodyne patents, 499
New era, 4, 17, 00, 61, 582
theory of, 351-362
New enterprises, 651, 656
security flotations by, 556
Newberry, J. J., Co., 536
New Hampshire, legal investments in,
127n

New Idea Co., 652»

New issues, 705
New jersey ^ino Co., 49n
*Je*/ lone Central R.R., 231, 615, 674
/Jew York, Chicago & St. Louis R.R., 119,
439, 440, 453, 617, 659, 660
New York City Omnibus Corp., 643, 644

New York Edison Co., 250, 251
New York & Erie R.R., 88
New York & Harlem R.R., 227n
New York moratorium law, 259n
New York, New Haven & Hartford R.R.,
83ra, 124n, 180, 249, 310n, 317
New York Public Service Commission,
473

New York savings-bank law, 107-147
New York Shipbuilding Corp., 271
New York State Bankers Association, 148a
New York State Railways, 241n
New Ycrk Stock Exchange, 48, 50n-52,
67, 184, 242n, 281, 301, 395, 398, 425,
*23, 434, 435, 444, 448, 581, G05n
New York Transit Commission, 52, 422
New York Water Service Corp., 179, 615
Niagara Hudson Power Corp., 474, 638,
641

Niagara Shares Corp., 255
Nicaragua, government bonds, 112
Nickel Plate (see New York, Chicago and
St. Louis Ry )

Niles-Bcment-Pond Co., 217
Nonconsohdated profits and losses, 436
Noncumulative preferred stock, 203, 265
Nondetachable warrants, 320
Nonoperating income, 159, 162
Nonrecurrent earnings, 529
Nonrecurrent losses, 416-423
Nonrecurrent items, 405, 406, 438
Nonvoting stocks, 71
No-par stock, 390
Noranda Mines, Ltd., 457
Norfolk & Western R.R., 95n, 165, 166, 191,
203, 206n

Normal-stock method, 421, 505, 625
Normal value, 686

North American Co., 47, 150, 265, 2G6/i,
273, 394-397, 436n, 474, 477, 636, 662,
709 n.

Northern Express Co., 439
Northern Pacific Ry., 74, 161, 251, 436>/,
437, 439

Northern Pipe Line Co., 561-563, 566, 581,
586

Northern States Power Co., 426n, 474
North-western Improvement Co., 439
Norway, government bonds, 112
Notes, bonds, 83
payable, 614

Obsolescence, 172, 488
hazard, 484-486, 501
Ogden Corp., 266n
Ohio Copper Co., 298
Ohio Oil Co., 460

844

SECURITY ANALYSIS

Office buildings, financing of, 139, 141
valuation of, 139
Oil companies, 38, 448, 657, 681
amortisation of, 456
Oil and Gas Journal, 52
Oil producing vs. refining, 461
Oil reserves, amortisation of, 496
Ontario Power Service Corp., 701
Operating ratio, railroads, 167
Oppenheim Collins & Co., 51
Option warrants, 72, 321, 635-647, 649,
658. 664

allowance for, 637-539
basis of trading, 637
in capitalisation structure, 644
dilution by, 645
list of, 644

vs. low-priced stocks, 640
method of payment under, 319, 637
purpose of issue of, 639
in reorganisation, 646
as speculative vehicle, 640-644
v8. subscription rights, 636
(see also Warrants)

Optional dividends, 387

"Optional” senior issues, 285n

Orders, unfilled, 38, 56

Ore reserves, amortization of, 493

Organisation expense, 424

Other income (see Nonoperating income)

Otis Co. (cotton), 572, 581, 586, 603

Otis Elevator Co., 191

Otis Steel Co., 47

Outlet Co., The, 228

Over-all method, 127

Overbuilding, 140

Overcapacity, 631

Overvaluation, 25, 40, 669

Owens-Illinois Glass Co., 19, 22, 365

Pacific Gas & Electric Co., 470, 474, 478
Pacific Lighting Corp., 474, 475
Pacific Mills Co., 589
Pacific Power & Light Co., 87, 88n
Pacific R.R. of Missouri, 89
Pacific Telephone <k Telegraph Co., 191
Packing companies, 39, 682
Pan American Petroleum Co., 301
Panama, government bonds, 112
Paper companies, 39
Par value (s), 210, 351, 390
effective, 570
of preferred stooks, 202
Paramount Pictures Corp., 20, 323
Parent company, V8. consolidated, 177
(see al8o Holding company)

Parity, definition of, 324

Park Avenue Corp., 487
Park & Tilford, Inc., 427-430, 492
Participating interests, allowances for, 539
Participating issues, 71, 304, 321-323
advantages and disadvantages of, 300
calculation for, 323
(see also Convertible issues)

Patents, 497-501, 532
amortization of, 49, 463
royalties on, 498
Patino Mines, 457
Penn-Ohio Edison Co., 639
Penney, J. C., Co., 228, 365
mining stocks, 59

Penn. Power & Light Co., 474, 475
Pennsylvania Coal Co., 439, 575
Pennsylvania-Dixie Cement Co., 119
Pennsylvania R.R., 3, 162, 209n, 345,
671

Pennsylvania Securities Commission, 314n
Peoples Gas, Light & Coal Co., 474
Pepperell Manufacturing Co., 575, 581, 583,
687

Pepsi-Cola Co., 691

Pere Marquette Ry., 95n, 251, 440, 453,
660, 661

Perfection Stove Co., 49n
Permanent investments, 4, 274
Per-share earnings, 417, 438
Personal element, 31
Peru, government bonds, 112
Petroleum Corp. of America, 639, 648-650
Phelps Dodge Corp., 457
Philadelphia Electric Co., 471
Philip Morris, 682n, 691
Philippine Ry., 216
Phillips Packing Co., 640
Pierce Oil Co., 329, 709n
Pierce Petroleum Co., 709n
Pillsbury Flour Mills Co., 97n
Pipe-line companies, 52-54, 171
Pittsburgh, Ft. Wayne & Chicago Ry., 190n,
223n

Pittsburgh Plate Glass Co., 51
Pittsburgh, Youngstown & Ashtabula Ry ,
205n

Pittston Co., 661
Plant expansion, 627, 631
Plymouth Cordage Co., 422, 621, 687, 776
Pocahontas Fuel Co., 49n, 166
Poland, government bonds, 112
“Poor’s Manual,” 54, 418
Popularity of enterprise, 679
Porto Rican-Amerioan Tobacco Co., 311
Postal Telegraph and Cable Corp., 52
Power and light companies (see Public
utilities)

“ Practical Business Forecasting,” 719n
Prairie Oil A Gas Co., 650

INDEX

845

Prairie Pipe Line Co. t 650
Pratt & Whitney Co., 217
Preemptive rights, 646n
Preferred stock(s), 5, 69, 544, 671, 685

vs. bonds, 185, 242, 334
book value of, 570

vt. common stock, 187, 335
disadvantage of, 553
dividends, 398
financing by, 193
high-grade, 77

v*. income bonds, 210
industrial, 192
noncumulative, 203
par value of, 202
pattern, 71
price range of, 184
protective provisions for, 261-273
public-utility, 192
sinking funds for, 263
speculative, 338-342, 672
of subsidiaries, 178
technique of selecting, 196-208
theory of, 184-195
valuation of, 569
voting by, 263
Preinreich, G., 360n
Premium on bond retirements, 413
Pressed Steel Car Corp., 120
Price-earnings ratios, 9, 530-540

factor in investment, 63, 04, 355, 366
inertia, 278
of product, 524
vs. value, 684-712

Prior-deductions method, 126, 171, 174-
176

Prior liens, prohibition of, 249
Private business, va. stock-market valua¬
tions, 350

test of investment, 368, 370
Privileged issues, 284-329, 724
extent of privilege, 296-298
principles governing purchase of, 290
vs. related common stock, 323-329
rules regarding retention, 292
technical features of, 295-326
terms vs. prospects, 295
(see also Convertibles)

“Problem of Investment, The,” 61»
Procter & Gamble Co., 191, 192, 202, 205,
365, 570n

Product, price of, 525
Production, costs of, 626, 559, 560
vs. volume, 560
Profits, corporate, 11
Promotors, fraudulent, 70
Property values, 134-144, 146
Proration laws, 459

Prospects (see Future)

Prospectuses, 46, 53, 472, 650n, 653
Protective committees, 237, 246-248
Protective covenants, 172, 235-260
Protective provisions for preferred stock,
261-273
Proxies, 598
Pseudo-utilities, 170
Psychology, mob, 423
of speculator, 695

Public Service Co. of Northern Illinois,
474

Public Service Commission of New York,
52. 469

Public Service Corp. of New Jersey, 178,
233, 474

Public Service Electrio & Gas, 191
Public utility (ies), 12, 14, 39, 40, 47,93.100,
125, 197, 436, 530, 561, 685
bank loans and, 614
bonds. 91, 94, 95. 128, 146, 156
analysis of, 169-176
comparisons, 674-676
depreciation, 465-479
definition of, 473

holding companies, 89, 92, 176, 177
maintenance, 471, 473-474
preferred stock, 192
property values, 146
rate regulation and, 146
rentals and, 180n
8.E.C. regulation, 146
state commissions, regulation by, 146
warrants, 641
working capital of, 182
Public Utility Holding Company Act, 53,
47In, 657, 668

Public Utility Holding Corp., 640
Purchase-money mortgages, 250
Pure interest, 101, 103
Pure Oil Co., 460
Purity Bakeries Corp., 442
Pyramiding, 41, 94, 059-668
of earnings, 434
by stock dividends, 397

Qualitative factors, 37-45, 679

vs. quantitative factors, 144, 508, 690
Quality, coefficient of, 402

differentials, 12-14
Quantitative factors, 37-45

vt. qualitative factors, 144, 508, 690
Quantitative standards, 9
Quarterly reports, 48

Quick assets, 181

(see also Current assets)

846

SECURITY ANALYSIS

Radio manufacturers! 14, 40, 516
Radio Corporation of America, 58, 464, 497
Railroad(s), 11, 36, 38, 47, 82n, 93, 100, 124,
125, 193, 197, 352, 436, 446n, 561, 681
analysis, geographical differences in, 163
bank loans to, 614

bonds, 4, 12, 94-96, 125, 128, 156-169,
685, 705n
analysis of, 157
low-priced, 164
vs. busses, 166
comparisons, 6G9-674
depreciation of, 446n
financing methods of, 99
fuels, 165-169

consumption of, 167
hard-coal, competition and, 166
holding companies, 668
maintenance costs, 167
operating ratio, 167
reorganizations of, 240n, 702
soft coal, 165
stocks, 12
va. trucks, 166
trusteeships, 702
working capital of, 182
Railway Age, 52

Rand Kardex Bureau, 288, 291, 297, 319,
329

Rate regulation, 40, 146, 675
Reading Co., 95n, 16Gw, 435, 696
Readjustment plans, voluntary, 243-245
Real estate, 34
bonds, 138, 156
depreciation of, 143
securities, 487

guaranteed, 220-223
location of, 143
**milking” of, 142

Recapitalization (see Reorganization)
Receivables, 579

Receivership, 82, 83, 236, 557, 700
(see also Default; Trusteeship)
Reconstruction Finance Corp., 24on, 654
Record(s), of dividends, 107
of solvency, 107
Refrigeration, 14
electric, 39
Regal Shoe Co., 49n
Registration statements, 53, 447
Regulation, 13, 146, 512
of rates, 40

Related issues, comparison of, 709
Reliable Stores Corp., 297
Reliance Management Corp., 137
Remedies (see Protective covenants)
Remington Rand, Xno., 202, 270, 636n

Rentals, 178, 227-232, 558
capitalization of, 139
ground, 143
joint-facility, 159
obligations, 155, 677
public-utility, 180n

Reorganization, 82, 90, 203, 237-248, 262,
701

railroad, 240n, 702
Replacements, 446, 454, 465
Reports, consolidated, 177
periodic, 48, 51

Reports, to stockholders, 46-51
Republic Iron & Steel Co., 626, 708
Republic Steel Corp., 120n
Repurchase, of shares, 605-609
of senior securities, 412
Research, 366

Rcscrve(s), contingency, 501-505
accounts, foreign, 379
for inventory losses, 418-420
voluntary, 568
Restaurants, 682
Restricted shares, 539
Retail enterprises, 227, 229
Retirement(s), 459, 461
of bonds, 413
reserve, 470

(see also Depreciation)

Revaluation, 446
Revenue Acts, 421n

(see also Federal Revenue Act)

Reverse split-ups, 310
Reynolds Investing Co., 255n
Reynolds, R. J., Tobacco Co., 301n
Rhea, Robert, 715n
Richfield Oil Corp., 241n
Rights (see Subscription rights)

Ripley, Wm. Z., 172n

Risk(s), conversion privilege as compensa¬
tion for, 286
cyclical, 102
v8. yield, 101, 189
Rock Island Co., 660, 668
Rodkey, R. G., 194n, 207n
Rolbein, D. L., 388n
Royal Baking Powder Co., 264
Royalties, on patents, 498
Rubber companies, 526
Rumania, government bonds, 112
Russia, government bonds, 112

Safety Car Heating & Lighting Co., 489-492
Safety, factor of, 128n
vs. income, 592
in investment, 63

margin of, 92, 96, 97, 128n, 278, 716, 720
of principal vs. risk, 60, 61

INDEX

847

Safety, standards of, 62, 105-156
Safeway Stores, Inc., 638
St. Joseph Lead Co., 457
St. Louis-San Francisco Ry., 19, 22, 203,
205n, 208n, 661

St. Louis Southwestern Ry., 204n, 213 .
St. Paul & Kansas City Short Line, 168n
Salvador, government bonds, 112
Saltex Looms, Inc., 233
Sale of business, 583-586
San Antonio & Aransas Pass Ry., 225
San Diego Consolidated Gas & Electric Co.,
470

San Francisco Toll-Bridge Co., 304
San Joaquin Light 6c Power Corp., 315n
Sao Paulo, llOn

Savings-bank, investments, 106-147
law, New York, 107-147
Savings Bank Trust Co. of New York, 109
Savings plans, 722
Savoy Plaza Corp., 214n
Schackno Act, 239n
Schamus, S. L., 650»

Schletter 6c Zander, Inc., 360
Schulte Retail Stores, 226
Schwartz, Carl II., 218n
Scott Paper Co., 193/i, 365
Scrip dividends, 646
Scullm Steel Co., 319, 644
Seaboard Air Line Ry., 136
Seaboard-A11 Florida Ry., 81
Seager, H. R., and C. A. Gullick, G95n
Seagrave Corp., 394

Scars, Roebuck & Co., 380n, 393n, 394n
Seasoned issues, 704-707
“Seasoning,” 321
Secondary issues, 687-694
Secular expansion, 363
Securities and Exchange Acts, 1933—1934,
49, 127, 653, 656

Securities and Exchange Commission, 24,
46, 49, 50, 53, 72n, 127, 146, 229, 238,
239n, 242n, 263n, 266n, 273n, 280n,
286n, 406n, 420, 426, 430, 447, 454, 456,
471n, 598n, 600n, 609n, 646, G50n, 656,
663n

Security(ies), analysis, limitations of, 17*
30, G82

vs. market analysis, 713-722
opportunities of, 403
scope of, 17-30
utility of, 423
classification of, 69-77
clause, equal-and-ratable, 249
exchange of (see Switching)
fraudulent, 70
insurance, 410

Security(ies), gilt-edged, 274
market value of, 409-412
sale of, 408

senior, repurchase of, 412
standard patterns of, 71
undervalued, 355
Segregations, 695
Semiannual reports, 48
Senior-bond coverage, 128n
Senior issues, commonizing of, 339, 342
comparison of, 707-709
low-grade, 330-342
vs. junior issues, 84-88, 143, 709, 724
repurchase of, 412
Sen**! laturitics, 258
Servel, Inc., 271
Shabacker, R. W., 715n
Shaffner, Felix I., 61n
Shares, repurchase of, 605-609
Shattuck, F. G., Co., 424n
Shawimgan Water 6c Power Co., 315n
Shawmut Association, 591
Shawmut Bank Investment Trust, 591
Sheaffcr, W. A., Pen Co., 50n
Sherwin-Williams Paint Co., 365
Shipping companies, 39
Shoe companies, 682
Shoe-string common stocks, 552
Short sales, 328n, 686
Short-term issues, 118, 119, 120n, 132
cs. long-term issues, 315
Short-term investment, 60, 726
Siemens & Ilalske, A. G., 305, 322
Signature Hosiery Co., 360, 604
“Signs of the Times,” 611n
Silk-hosiery manufacturers, 40
Simms Petroleum Co., 605n
Sinclair Oil & Refining Corp., 641, 643
Sinking fund(s), 256-260, 711
depreciation method, 476
for preferred stock, 263-269
Size of enterprise, 13, 107, 113-116, 706
of investment, 726
of issue, 698
Skelly Oil Co., 252
Sliding-scale privileges, 310, 318
Sloan, Lawrence H., 60n
Smith, A. O., Corp., 97n
Smith, E. L., 357
Snuff companies, 205, 206, 516
Socony-Vacuum Corp., 97n, 459
gr/t-coal railroads, 165
Solvay American Investment Corp., 636
Solvency, record of, 107
Southeastern Power & Light Co., 639
Southern California Edison Co., 474, 475
Southern Pacific Ry., 225, 315n
Southern Ry., 224, 709

848

SECURITY ANALYSIS

8palding, A. G., Sc Brew., 264, 266
Spanish River Pulp Sc Paper Mills, Ltd., 322
Spear Sc Co., 708
Speculation, 10, 727
analysis and, 27-30
commonHBfock, 8
drawbacks of, 276
vs. gambling, 66
intelligent, 67

os. investment, 57-68, 354, 392, 545, 725

long-term, 60

meaning of, 349

types of, 66

unintelligent, 67

Speculative capitalization, 547-553, 557
Speculative components, 67, 513
Speculative senior issues, 8, 330-342
unpopularity of, 334
(see also Convertible issues)

Speculative value, 68
Speculator, os. analyst, 42, 607
psychology of, 695
Split-ups, 389-391, 694
Stability, 25, 43, 92, 349, 352, 508
Staley, A. E., Manufacturing Co., 549-552,
557

Standard Brands, Inc., 191
“Standard Corporation Records,” 54
Standard Gas and Electric System, 120,
177

Standard issues, oa. nonstandard issues,
692

Standard Oil Export Corp., 190n
Standard Oil Co. of Indiana, 97n, 459n,
485

Standard Oil Co. of New Jersey, 84, 97n,
318, 365, 459n

Standard Oil Co. of Nebraska, 485, 604
Standard Oil Group, 47, 52
Standard patterns of securities, 71
Standards of safety, 62, 106, 156
Standard Statistics Co., 149n, ICO, 570n,‘
712n, 828n

“Standard Statistics' Industrial Stock
Index,’’ 10, 18, 50n, 54, 231, 420n, 438
State bonds, 121-122

State commissions, public utilities regulated
by, 146

Stated capital, 269
Statements, listing, 448
Statistical Abstract, 56
Statistical services, 54
Steel industiy, 57, 509, 631, 681
Steel, production of, 718
Steel Sc Tube Co. of America, 698
Stevens, W. H. S., 266n
Stewart-Wamer Corp., 422, 620n
Stock Exchange, New York (see New York
Stock Exchange)

Stockholders, action by, 566, 582
information to, 597

Stockholders vs. management, 388, 594-610
reports to, 46-51
Stockholdings, of officers, 598
“Stock Market Profits,” 715n
Stock(s), bank, 61, 62, 411
88. bonds, 59
low-priced, 330, 333
borrowing of, 328

capitalization vs. bonded debt, 145-156
common (see Common stooks)
dividends, 389-400, 694
effect on cash dividends, 392
periodic, 393-400, 663
preferred stock, 398
pyramiding by, 397
valuation of, 433-435, 662
equity test, 146
“growth,” 725
for investment, 59
low-priced, 554-559
vs. option warrant, 640
market, 683
nature of, 531

valuations vs. private business, 850
non voting, 71
no-par, 390

option warrants (see Option warrants)
options, 653

preferred (see Preferred stocks)

purchase warrants (see Option warrants)

sales of, 99

speculation in, 59

value ratio, 145-156, 197, 202

“watered,” 351, 353, 379, 492

yields, 14

Stokely Bros. Sc Co., 613, 618
Stop-loss orders, 718
Storage companies, 94
Store buildings, financing of, 141
valuation of, 139
Straight investments, 74
Straight-line depreciation, 469, 473, 476
Street railways (see Tractions)

Studebaker Corp., 43, 44, 243, 279n, 327,
508, 584, 607n, 627, 700
“Study of Corporation Securities,” 225n,
643n

Subscription rights, 639n, 646, 663

issues with (see also Convertible issues)

88. option warrants, 636
Subscription warrants, 98 (see also Option
warrants)

Subsidiary companies, 435-444
bonds of, 232-234
common stock of, 179
dividends from, 178, 672
losses of, 441

INDEX

849

Subsidiary companies, preferred stocks of,
178

undistributed earnings of, 164
Sugar companies, 39, 48, 96, 681
Sulphur companies, 456
Supermaturity, 366
Supervision of investments, 274-283
Surety companies, 222
Surplus, adjustments of, 49
compulsory, 382

Surplus vs. income account, 403, 417
items, 568

reserve charged to, 505
Survey of Current Business , 52, 55
Sweden, government bonds, 112
Swift & Co., 229, 371n, 420, 769-772
Switching, 277, 325, 707-712
Switzerland, government bonds. 111, 112

Tampa Electric Co., 471
Tangible assets, 351, 379
values, 567

Tax(es), chain stores affected by, 688
exemption. 711, 726
federal (see Federal taxes)
income (see Federal taxes)
refunds of, 415
undistributed profits, 386
Taxation, dividend policy and, 378, 386-
388

Taxicab companies, 170
Technical market signals, 15
Technical study of market, 715-718, 722
Telegraph companies, 127n
Telephone companies, 93, 127n, 174
bonds of, 115
Texas Co., 523

Texas Gulf Producing Co., 462, 496
Texas Gulf Sulphur Co., 457, 523n
Theater companies, 227
“Theory of Dividends, The,” 360n
“Theory of Investment Value, The,” 360n,
510n, 644 n
Thermoid Co., 271
Third Avenue Ry., 241n, 471
Thompson, J. R., Co., 52
Tidewater Associated Oil Co. f 459n
Tidewater Power Co., 471
Tighe, L. G., 727n
Timing factor, 15, 32
of investment, 369
Tire companies, 682
Title Guarantee & Trust Co., 142
Trico Products Corp., 539
Tobacoo companies, 682
Tobacco Products Corp., 191n, 224, 257,
433, 564, 566, 664

Toledo, St. Louis & Western R.R., 660

Total-deductions method, 127, 198
Traction issues, 11, 35,39, 93,109,169,193,

205, 352

Trade journals, 56
Trading, 725
in bonds, 687
costs of, 717, 720
maiginal, 686
in the market, 371
Trafhc, character of, 165
density of, 168
diversification of, 158, 165
Trainload, average, 158, 167
Trails. 'Station, bus, 40
ratio, 167

Trend(s), 13, 21, 130, 131

of earnr;gs, 40-42, 349, 352, 358, 583
to. average, 359, 611-513
irregular, 517
projection of, 359
Trico Products Corp., 50n
Tri-Continental Corp., 644
Trinity Buildings Corp., 143n, 214n, 238n
Tri-State Telephone & Telegraph Co., 115
Tri-Utilities Corp., 179
Triumph Explosives, Inc., 639
Trucks, vs. railroads, 165
Truscon Steel Co., 394n
*' Trust and Corporation Problems,” 696n
Trust Indenture Act, 238, 245
Trustee(s), 238

indenture, 240, 245-248
Trusteeship, 236n, 685
railroad, 702

(see also Receivership)

Trust-fund investments, 106-147
Trusts, investment, 355-357, 371, 412, 670n,
690

Tubize-Chatillon Corp., 571
Tung Sol Lamp Co., 700n
Turn of market, 28

Underlying bonds, 88, 251
Undervaluation, 25, 353, 565, 669, 698,
724

“Undistributed Profits Tax, The,” 388n
Unfilled orders, 38, 55
Union Carbide <fc Carbon Corp., 223, 365
Union Electric Co., 470
U- **n Pacific R.R., 89, 95», 150, 384, 487,
673, 711

United Aircraft & Transport Corp., 305
United Biscuit Co. of America, 150, 305n
United Corp., 65n, 644
United Cigar Stores Co., 52, 228, 413, 435,
565, 664

United Cigar*Whelan Stores, 413

850

SECURITY ANALYSIS

United Drug Co., 232, 413
United Light A Railways Co., 179n
United Fruit Co., 50n
United Engineering & Foundry Co., 50n
United Gas Corp., 616
United Gas Improvement Co., 474
United Light & Railways Co., 667
United Merchants & Manufacturers, 415
United Shipyards Corp., 586n, 604, 697
U. S. Cast Iron Pipe & Foundry Co., 204,
499

U. S. Coal Commission, 53
U. 8. Express Co., 70n
U. S. Fidelity A Guaranty Co., 223
U. S. & Foreign Securities Corp., 659n
U. S. Government securities, 58, 65n, 711,
712, 726

Liberty Bonds, 32n, 60
price range of, 184
Savings Bonds, 8, 275-277, 722
U. S. Hoffman Machinery Corp., 498
U. S. Industrial Alcohol Co., 215, 417, 489,
619

U. S. Leather Co., 49, 273
U. S. Lines Co., 205n
U. S. Radiator Corp., 252, 253n
U. S. Realty & Improvement Co., 214n,
238n

U. S. Rubber Co., 120, 418, 627, 704
U. S. Steel Corp., 2, 47, 48, 50-52, 91, 97n,
187, 256, 304n, 376, 380, 407, 413, 415,
508, 515, 516n, 568, 628-631, 633, 667,
723

U. S. Tobacco Co., 191, 206
United Steel Works Corp., 304
Universal Pictures Co., 2G4, 334
Unseasoned issues, 704-707
Unsecured debt, 261
Upset price, 238

Uruguay, government bonds, 112
Utah Securities Corp., 412
Utica, Clinton & Bingbampton R.R., 214n
Utilities Power & Light Corp., 266n
Utilities Service Co., 173

Valuations, business, 574
judicial, 577n

Value(s), book (see Book value)
current-asset, 148
going-concern, 147
intrinsic, 19-27, 68, 624, 721
liquidating, 12, 148n, 578-611), 624
market (see Market value)
normal, 686
vs. price, 684-712

Van Sweringen, O. P. and M. J., 659-661,
668

Vaneas Co., 661
Ventures (see Enterprises)

Ventures, Ltd., 709n
Vermont, 111, 125n, 127n, 172n
Virginian Ry. Co., 165, 166n
Virginia Transportation Corp., 661
Volume vs. production costs, 560
Voting, by bondholders, 241
control, 253, 259
by preferred stock, 263-269
rights, 188, 263-269. 273

Wabash R.R., 136, 204, 213n, 322, 440
Wage rates, 50
Waldorf System, Inc., 52
Walgreen Co , 637
Wall, H., 611n
War, earnings, 633
effect of, 693
of 1914-1918, 5
of 1939-, 5

Ward Baking Co., 707
Warner Bros. Pictures, Inc., 199, 271,
28 5n

Warrant-bearing issues, 318-321
advantages of, 302-307
vs. convertibles, 302
(see also Option warrants)

Warrants, detachable, 320
nondetachable, 320
option (see Option warrants)
public-utility, 640

Warrants, stock-purchase (see Option war¬
rants)

subscription, 98

(see also Option warrants)

Warren Bros. Co., 435n
Washington Ry. & Electric Co., 215
Wasting assets, 257
Water companies, bonds, 109
“Watered" stock, 351, 353, 379, 492
Watson, J. W., Co., 518
Welding companies, 172
Western Auto Supply Co., 618
Western Maryland R.R., 165, 326n
Western Pacific R.R., 440
Western Union Telegraph Co., 216, 472
Westinghouse Electric and Manufacturing
Co., 36, 300, 322, 329
Westmoreland Coal Co., 566n, 608
West Penn Electric Co., 198, 199
Westvaco Chlorine Products Corp., 223
West Virginia Pulp & Paper Co., 252
Wheeling & Lake Erie Ry„ 436, 439, 661
Wheeling Steel Corp., 251
White Eagle Oil & Refining Co., 318
White and Kemble, 157n

INDEX

851

White Motor Co., 579-581, 684, 598, 600
White Rock Mineral Springs Co., 299, 301
White Sewing Machine Corp., 302, 304
Wilcox, H. F„ Oil & Gas Co., 271
Willett & Gray, 52
Williams, J. B., 3C0n, 510n, 644n
Willys-Overland Co., 92, 260, 337, 760
Wilson & Co., 252, 420
Wisconsin Gas & Electric Corp., 265
Woolen companies, 39
Woolworth, F. W. Co., 43, 48, 379, 390,
409, 436, 463

Working capital, 181-183, 335-338, 537,
611-616, 620
maintenance of, 263
requirements, 252

World Almanac, 56
World War (1914-1918), 5
World War (1939- ), 5

Wright Aeronautical Corp., 19, 23, 693
Wright-Hargreaves Mines, Ltd., 550
Write-downs, of fixed assets, 459, 489-493
of intangibles, 270

Yale University, 727n
Yield(8), bond, 14
vs. nsk, 101, 189
stock, 14

Youugotown Sheet & Tube Co., 251, 272,
422, 453, 510, 698

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